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Can Options Replace The Need For Diversification?

We have all been cautioned since the first time we thought about investing, that we must diversify. You cannot invest in any one issue or even market, because the risks are too high.

Are they really?

What if your investment strategy is to seek 4% dividend yield? Would it be all right to put all of your capital into stocks yielding 4% or more? Many will say no, that this by itself does not diversify your portfolio. But if the goal is income, there are plenty of ways to diversify and earn 4% to 5% in annual dividends. This is one way to effectively spread risks; but a bigger question is whether diversification even makes sense.

Two popular quotes on this topic are:

"Wide diversification is only required when investors do not understand what they are doing."

Warren Buffett

"Diversification is for idiots."

Mark Cuban

The problem with diversification is that it tends to offset profits and losses, resulting in a net very close to zero gain (or loss). It is a way of admitted that the market cannot be beaten, which is easily shown to be untrue.

With hedging strategies, you can beat the market and gain better than average returns. As a starting point, dozens of high-quality companies do yield attractive dividends above 4%. Even beyond this, numerous options strategies yield net income while completely eliminating market risk, often at no net cost to the trader. For example, a synthetic short stock position entered to protect currently held stock is one such strategy. This combines 2100 shares of stock with a long put and short call, both options opened at the same strike.

The short call is covered by stock. The timing of this is excellent when the stock's price has peaked and you expect it to decline. The combined options will mirror the movement in stock point for point below the strike price. So a decline of five points will be offset by an increase of 5 points in intrinsic value in the long put.

There are many other strategies that protect against market risk. For example, an installment put involves buying a long-term LEAPS put, which is expensive; and paying for it by writing a series of very short-term covered calls or uncovered puts. These should expire in one to two weeks, when time decay is accelerated. Over the year between now and expiration of the long LEAPS put, the repetitive short calls or puts will pay the premium. The strikes should be out of the money to avoid exercise over the short term the short calls or puts are open.

The outcome: If the stock price rises by expiration of the short put, you have not lost anything because the net cost of that LEAPS put is zero. You have bought many months of complete elimination of market risk. If the stock price falls below the put, you have a choice. Either sell the long put to take profits that offset paper losses in the stock, or exercise the long put and sell shares at the strike above market vale.

This has eliminated market risk completely with no net cost. In this type of hedging, there is no need for diversification. You hedge the market risk completely.

With that level of hedging, who needs diversification?

My recently released book talks about this topic in great detail. "Making Money with Option Strategies" ("Powerful Hedging Ideas for the Serious Investor to Reduce Portfolio Risks") has just been released. You can find this book at tinyurl.com/z44kzlu

Michael Thomsett blogs at TheStreet.com, Seeking Alpha,and several other sites. He has been trading options for 35 years and has published books with Palgrave Macmillan, Wiley, FT Press and Amacom, among others.