DOWNSIDE PROTECTION

How Does That Enhance Your Upside?

Same Reason Low IV Does!
Joseph R. Stadelnikas, M.D., M.B.A.

Very interesting question. I talk a lot about DSP (downside protection)

and avoid high IV and both for the same reason. From the beginning, I
did not trade for the excitement or to exit quickly with short term profits.
But, in it for the Long Journey. Been on this journey well before there
were any option groups or option websites/blogs. Those are relatively
new, but they are often filled with stories of big wins in strong markets
with high IV, high flying tech stocks & others. Investors seem to be less
excited about downside protection and why it should be key attribute in
long term trading success.

Downside protection is a risk-management strategy, yes, one of those

things being a part of a trading plan, that attempts to reduce the
frequency and magnitude of losses in one’s portfolio. Most are familiar
with the importance of compounding returns. A portfolio that needs to
recover from a loss, IS NOT COMPOUNDING WEALTH, it is just
playing catch up.

This DSP strategy can actually contribute to a positive rate of

return. My average IV, downside protection, portfolio is spending
more time compounding my rate of return than a high IV portfolio does
when it is still recovering from losses. (Why the Tortoise can beat that
Hare, being smarter, with a plan).

Most investors know that in the short term, compounding is not always
obvious, but it does make a big difference in your long term portfolio.
The power of compounding comes from your returns generating more
returns as time goes by, like the snowball effect. It is generating profits,
while other portfolios are just recovering from losses. This concept is
important, read again. This power of compounding is evident when
looking at upside gains, but it is hidden and important for downside
protection. Remember, the less you lose, the less you need to recover.
That excess dollar you return in a down market, recovering faster, with
an average IV portfolio over a high IV portfolio, is worth far more that
that excess dollar a high IV portfolio returns in an up market. For long
term success it is important to grow your upside, but it is far more
important to protect your downside. You want smaller losses and faster
recovery, so you are returning to compounding faster and not just
recovering.

So why is downside protection (dsp) so important. It is pretty obvious.

It is difficult to recover from large losses. We all know a 20% decline
takes a gain of 25% to breakeven before a profit is realized. A 40%
decline, a gain of 67%.

We are all familiar with the story of the Tortoise and the Hare. Story
showing the Tortoise beating the Hare by being more consistent over
their long journey. In our version of this fable, let’s call our Tortoise the
average IV runner and the Hare the high IV runner. Like investing the
Hare starts out with a sprint, always pointing out his performance, often
mentioning to the Tortoise his poor performance.

The High IV Hare, runs faster, but he does have those trips and falls.
His losses often deeper and slower to recover, before he regains his
stride again. During those declines, his dollars are not compounding
profits, but recovering from his losses.

The Average IV Tortoise, however, runs slower, does have declines, but
recovers from those declines faster, allowing his dollars to keep on
compounding a longer period of time.
One other important point about these two creatures from my
experience, one focuses so much on returns, they rarely have extra cash
reserves to take advantage of those declines. The other often does. Who
wins at the end not so important to me. I have been through 9 bear
markets, I have seen many of those High IV Hares have those stumbles
and those staying in the race do as well as the Average IV Tortoise. But,
I have seen many of those High IV Hares leaving, maybe broke, no cash
to take advantage of a great opportunity. Poor planning. In this long
race, I wonder which one is having the more relaxing journey. Are you
a Hare or a Tortoise?

QED