35 lines
2.2 KiB
Plaintext
35 lines
2.2 KiB
Plaintext
174 • The Intelligent Option Investor
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Understanding Leverage’s Effects on a Portfolio
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Looking at leverage from a lambda or notional control perspective gives
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some limited information about leverage, but I believe that the best way
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to think about option-based investment leverage is to think about the ef-
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fect of leverage on an actual portfolio allocation basis. This gives a richer,
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more nuanced view of how leverage stands to help or hurt our portfolio
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and allows us more insight into how we can intelligently structure a mixed
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option-stock portfolio.
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Let’s start our discussion of leverage in a portfolio context by thinking
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about how to select investments into a portfolio. We will assume that we
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have $100 in cash and want to use some or all of that cash to invest in risky
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securities. Cash is riskless (other than inflation risk, but let’s ignore that
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for a moment), so the risk we take on in the portfolio will be dampened
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by keeping cash, and the returns we will win from the portfolio will be
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similarly dampened.
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We have a limited amount of capital and want to allocate that capital
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to risky investments in proportion to two factors:
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1. The amount we think we can gain from the investment
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2. Our conviction in the investment, which is a measure of our per -
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ception of the riskiness of the investment
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We might see a potential investment that would allow us to reap a profit
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of $9 for every $1 invested (i.e., we would gain a great deal), but if our
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conviction in that investment is low (i.e., we think the chance of winning
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$9 for every $1 invested is very low), we would likely not allocate much of
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our portfolio to it.
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In constructing a portfolio, most people set a limit on the proportion
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of their portfolio they want to allocate to any one investment. I personally
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favor more concentrated positions, but let’s say that you paid better atten-
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tion to your finance professor in school than I did and figure that you want
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to limit your risk exposure to any one security to a maximum of $5 of your
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$100 portfolio.
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An unlevered portfolio means that each $5 allocation would be made
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by spending $5 of your own capital. Y ou would know that if the value of
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the underlying security decreases by $2.50, the value of the allocation will |