A Lower Risk Option for Options: Passive Risk Management

Read Part I to learn how a passive overlay helps independent advisors and investors use options to manage downside portfolio risk.

Philip Sun, Co-Founder and CEO of Adaptive Investment Solutions LLC, explains the firm’s initial offering this way:

“Our first product manages the downside risk of stock portfolios using options. Options have been around for a very long time, but investors have mostly used them for speculation, rather than what they were actually invented for: reducing investment risk at a reasonable cost. Before 2015 the liquidity needed for mass-automation just wasn’t there. But over the last 10 years options data has been maturing. Now, a number of institutions along the so-called “options supply chain” – the Cboe, NASDAQ, advisory firms, and so on – have been generating real enthusiasm for using options as a natural way to hedge.”

For Adaptive to achieve its potential, says Sun, the firm has to be ready to scale organically. That’s why management is laser-focused on keeping costs low.

“For our current users – financial advisors — we use IBKR’s API with multithreading and real-time market data to retrieve live option prices. But that’s costly when you plan to scale to a much bigger user base. If our ultimate target audience can’t afford our tools we’ll miss the mark, and we don’t want to restrict the capabilities for them.”

To control costs for non-advisors, Sun and his team give them delayed market data and cap the number of accounts and stock positions. Advisors pay considerably more but are under no such restrictions.

“For most non-advisors full functionality is more important than real-time data, but if they want it, it’s just an extra fee.”

Sun believes Adaptive can make an impact in options trading for two reasons, one philosophical, the other more technical. The philosophical reason has to do with mission.

“We believe small investors should have access to the same sophisticated strategies as large investors enjoy.  Over the years, options increasingly came to be used for speculation. The added risk gradually put them out of the reach of independent advisors and investors, not because options are inherently risky, but because using them for speculation requires careful timing, and often leads to high implicit leverage. Well, when you limit engagement, you tend to limit liquidity, whereas we believe more liquidity is good for markets and sectors.”

Which brings us to the second reason: Adaptive is using trading technology in a new way.

“We’ve learned how to use technology to customize the return profile of portfolios using options, and use them for downside risk management. Doing that inexpensively is pretty unique. IBKR is a good platform for us because it’s very strong in options and its API’s make it extremely adaptable. Right now, few tools built on top of it look at portfolios through the lens of options and put them to use as risk hedges. Using a ‘risky’ class of investments for protection against risk sounds counter-intuitive.”

In fact, Sun contends, it’s a “better, more cost-effective approach than most other downside strategies. If you give our tool a stock portfolio, it’ll compare it to an index, then use index puts to hedge against the downside. The key is the holistic approach: we analyze an entire portfolio at once, which is hard for most retail-level tools to do.”

From the start, Sun says, the firm saw the perceived ease and security of passive investing as a functional analogue.

“Index funds, balanced funds and the like bring less-experienced investors peace of mind. With no active management needed, retail investors feel they won’t be upended by unexpected spikes. Their financial advisors mainly focus on asset allocation and can generally keep an eye on things at the asset class level pretty well.”

Sun explains that though using options to hedge is more powerful and effective, it’s undeniably an active process: at a minimum, investors need to roll over their option positions when they expire, which requires some technical knowledge and carries the risk of execution errors.

“What we do is overlay the active power of options hedging with the passive management characteristics that add peace of mind. Investors choose a strategy, we handle the rest. Hedging with options becomes, in effect, a passive solution that delivers more than passive management.”

Stay tuned for Part Three to learn more about Sun’s informed views and concerns about AI in general, and Generative AI in particular.