When describing the new Defined Outcome investments, a common question that I get is, “How do they do that?”.
In other words, how can an investment just “not lose money” if the market is actually down?
The answer is the use of options.
A call option gives the owner the right (option), but not the obligation, to buy a security in the future at a particular price The purchaser of the option will pay a one-time price for this option.
Let’s look at what could happen in this scenario for the purchaser of the option…
#1. The security (S&P 500) makes gains after 12 months. In this circumstance, the owner of the option has the right to buy the S&P 500 after 12 months at a pre-defined gain. He will, of course, be out the money that was used to purchase the option 12 months ago. So he will not not be in a position to participate 100% in the gains with his funds, but he will participate in a majority of it.
#2. The security (S&P 500) loses after 12 months. In this circumstance, the call option will expire, worthless. The investment funds were never actually invested in the S&P 500 and so the funds will not have lost any money. The purchaser of the call option will be out the same cost of the option that was purchased at the beginning of the period.
In the case of the new Defined Outcome investments, the company uses 7 different types of options inside of it to execute the results. It is a bit complex, but the idea is the same. The ability to make gains when the market goes up, and the ability to protect from losses if the market goes down.
I’m thankful that there are people much smarter than me that put it all together and we are able to benefit from their expertise.
If you have any questions, please feel free to contact me.