First of all, an Integrated Options Portfolio does not fundamentally change what makes up a good portfolio.  What should be understood is that an Integrated Options Portfolio helps us determine “how” to own what goes in a good portfolio.

 

At its most basic, the term Integrated Options Portfolio, or IOP, is used by Desert Rose Capital Management to describe a portfolio where the shares of stocks and stock funds are not actually owned in the portfolio.  Instead, they are replaced with the equivalent amount of registered stock options on the same, or nearly the same, stock or stock fund.  Every situation will be different which is why our expertise is essential to getting the most from an IOP.  Let’s look at an example IOP:

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The desired portfolio is selected and each stock and stock fund is evaluated to see if an IOP structure would be an improvement (it usually is).

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Registered stock options on the same number of “ABC” Fund shares are purchased at a fraction of the cost of buying “ABC” Fund shares directly.  The remaining money is then used to purchase lower risk, income-producing assets. This process is then repeated for the other assets in the portfolio.

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The portfolio now consists of a large amount of lower risk, income-producing assets, and a small percentage of options.  Nevertheless, the portfolio has approximately the same stock or stock fund exposure as the original portfolio in Step 1.

Note that we still control the same size position in each stock fund as before through the options, yet only a fraction of the previous amount is actually exposed to the risks of those funds.

Why go through all this?

To answer that question, we will focus in on the comparison between owning shares of “ABC” Stock Fund directly versus through the Integrated Options Portfolio structure. By not owning the shares of “ABC” Fund, we will not have any shareholder rights (no dividends, voting, etc.), unless we decide to actually purchase the shares.   In this case, the dividends are 1%/year. We will not have to pay the “ABC” Fund expense fees which will save us 1.25%/year, but Desert Rose will charge a 1% fee to implement and manage the IOP. We will also assume that the fixed income money ($43,500) was put into bond funds (“RST” Fund), which historically have been more conservative and stable yielding 5%/year. Assumption for simplicity:

  1. Bond fund price remains constant.
  2. The account is a ROTH IRA, so taxes are not a factor.

Day 1:

Day 1

Okay, now let’s see what happens on the expiration day of the options if the price of the “ABC” fund doesn’t change for two years:

Day 730 $50 per Share:

Day 730

  • Dividends were approx. $1,000 (1%/year), but “ABC” Fund expenses were $1,250 (1.25%) for a $250 loss if owned directly.  (dividends and expenses based on $50,000 average account balance)
  • The “ABC” options value at expiration is the difference between the Market Price of $50/share and the Strike Price of $47/share multiplied by 1000 shares for a gain of $3,000.
  • With “RST” yielding 5%/year ($4,350), the Desert Rose Management Fee of 1%/year is $1,000, for a net gain of $3,350.

The IOP outperformed by $100….nothing to write home about, but hang in there and we’ll get to the good stuff. What happens if the “ABC” Fund was to go up by 50% to $75/share over the two years?

Day 730 $75 per Share:

Day 730 - $75/share

  • Dividends were approx. $1,200 (1%/year), but “ABC” Fund expenses were $1,500 (1.25%) for a $300 loss if owned directly. (dividends and expenses based on $60,000 average account balance)
  • The “ABC” options value at expiration is the difference between Market Price of $75/share and the Strike Price of $47/share multiplied by 1000 shares for a gain of $28,000.
  • With “RST” yielding 5%/year ($4,350) and the Desert Rose Management Fee of 1%/year is $1,200 (again, based on $60,000 average account balance), for a net gain of $3,150.
  • The IOP performed the same over the two year period as the directly held account.  Still not real excited? So let’s talk about one of the great characteristics of an IOP structure, what happens when the “ABC” Fund declines 50% by the expiration date of the options?

Day 730 $25 per Share:

  • Dividends were approx. $800 (1%/year), but “ABC” Fund expenses were $1,000 (1.25%) for a $200 loss if owned directly. (dividends and expenses based on $40,000 average account balance)
  • The “ABC” options value at expiration is the difference between the Market Price of $25/share and the Strike Price of $47/share multiplied by 1000 shares.  However, since we are not obligated to buy at $47/share, we will let the options expire worthless for a loss of $6,500.
  • With “RST” yielding 5% ($4,350) and the Desert Rose Management Fee of 1%/year is $800 (again, based on $40,000 average account balance), for a net gain of $3,550.
  • In this scenario, the IOP outperformed by $21,450 and we still have capital to purchase new option contracts to profit when the market recovers.

The IOP Wins Out

We’ve already looked at what would happen for three different price scenarios.  This is the chart comparing the IOP structure versus a direct ownership for all the possible “ABC” Fund prices at the expiration of the options for everything from a 100% loss to a 100% gain in “ABC”.
Under our present assumptions, the IOP has the equivalent upside potential with significantly less downside risk than if we were to simply buy the “ABC” Fund directly.

IOP vs Direct