Mitigating Point of Entry Risk

December 28, 2020

Sitting on cash & the market is overbought? One strategy for mitigating “point of entry” risk

The S&P 500’s continues to notch new all-time highs and is now trading over 17% above its 200 moving day average. (Chart 1) Historically the S&P 500 has declined between 5% to 11% once overbought conditions reached a range of 14% to 20% above the 200 moving day average. (Chart 2)

^SPX Chart

^SPX data by YCharts


Many investors have found themselves holding excess cash through the election and are now concerned about putting that cash to work given current market levels. A strategy to consider is one that uses options (puts and calls) to replicate a structured note. The advantage of this structure is that it is not a debt security issued by a financial institution
and it may be customized to the investors specific risk tolerance.
The table in the example below looks at two different replications of a structured note. One has a -10% downside buffer and the second has a -20% downside buffer. It is important to understand that the more downside protection an investor desires, the less they will participate on the upside.

For example:
The -10% buffer structure would produce a return of -10.36% if the market fell -20%. The investor is capturing 52% of the downside. The trade-off is that the investor would only capture 67% of the upside, or 13.43% if the market returned +20% by expiration. If the investor had the -20% buffer structure in place, they would be flat if the market fell -20%. The trade-off is that the investor would only capture 42% of the upside, or 8.5% vs. 13.43% with the -10% buffer if the market returned +20% by expiration.

As you can see, there is no free lunch when it comes to investing. In the example above, clearly the investor will give up more of the upside to have greater downside protection. 

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