Smart Investor: diversifying with long-term options in defensive ETFs - a case study

• Euro holdings: €30,305
• USD holdings: $107,058
  (Assuming an exchange rate of 1 EUR = 1.1127 USD)

Total portfolio value:

• Euro holdings (converted to USD): €30,305 × 1.1127 = $33,719
• USD holdings: $107,058

Total portfolio value: $33,719 + $107,058 = $140,778

This portfolio is heavily weighted towards U.S. tech stocks like Microsoft (MSFT), Alphabet (GOOGL), and NVIDIA (NVDA). While these stocks provide great growth potential, they are vulnerable to economic headwinds. We aim to diversify 25% of this portfolio into defensive sectors to better balance risk and reward.

Why did we choose to diversify 25% of the portfolio?

In this article, we’ve chosen to diversify 25% of the portfolio into defensive sectors. However, it’s important to emphasize that this number was selected purely for the purpose of demonstrating the strategy and does not represent an ideal or recommended percentage for all investors.

How much you diversify depends on several factors:

1. Your market outlook: If you expect more volatility in tech stocks or economic uncertainty, you might want to allocate more than 25% into defensive sectors to protect your portfolio.
2. Your risk tolerance: The higher the percentage you diversify, the more you reduce the concentration of risk in a single sector. If you prefer lower risk and greater stability, you may want to diversify a larger portion of your portfolio. Conversely, if you’re more comfortable with market risk and prefer to maintain a higher exposure to growth sectors like tech, you might diversify a smaller percentage.
3. Your investment goals: Each investor has different financial goals. If you’re closer to retirement, for instance, you might prefer a more conservative portfolio with a higher allocation to defensive sectors. On the other hand, younger investors with a longer time horizon might choose to diversify less and maintain more exposure to growth sectors.

In this example, 25% was chosen as a random number to showcase the impact of diversification. It’s not a fixed rule or a recommendation, but a starting point to illustrate how using options can help spread risk. The actual percentage you choose should be based on your personal financial goals, market outlook, and risk profile.

Why diversify now?

While big tech stocks provide growth, they are also sensitive to macroeconomic conditions, particularly interest rates and market volatility. In recent years, rising interest rates have hurt tech stocks because higher borrowing costs affect future earnings. At the same time, inflation and geopolitical instability increase uncertainty.

To reduce concentration risk, we will add exposure to defensive sectors like utilities, real estate, treasuries, and gold. These sectors typically perform better during market downturns, providing a hedge against economic slowdowns and high volatility.

Introducing the diversification strategy

We will allocate 25% of the total portfolio ($35,195) into four defensive ETFs using long-term options (LEAPS). These ETFs have been chosen for their historically strong performance during economic uncertainty:

1. Utilities (XLU): A cornerstone of defensive investing, utilities provide essential services, making them less volatile.
2. Real Estate (XLRE): Real estate investments, particularly through REITs, generate steady income, especially when interest rates are low.
3. Treasuries (TLT): U.S. Treasury bonds are considered safe-haven assets, performing well during periods of market stress.
4. Gold (GLD): Gold is a traditional hedge against inflation and currency risk, known to perform well during times of economic instability.

MiFID II considerations for European investors

For European clients, it’s important to note that many of these U.S.-listed ETFs, such as XLU, XLRE, TLT, and GLD, are not directly tradeable due to MiFID II regulations. MiFID II restricts access to ETFs that do not comply with European investor protection standards, meaning these products are often not available for direct purchase by retail investors in Europe.

However, a workaround is trading options on these ETFs. MiFID II does not prohibit European retail investors from trading options on U.S.-listed ETFs, allowing you to gain exposure to these sectors through options contracts while still adhering to regulatory restrictions.

In this case, by using long-term options (LEAPS) on these ETFs, European investors can still benefit from price movements in these defensive assets without needing to own the ETFs outright.

The impact of interest rate cuts

This week, the Federal Reserve is expected to cut interest rates for the first time since 2020, which could directly benefit the defensive sectors we’ve chosen:

• Utilities (XLU) and real estate (XLRE): Both sectors benefit from lower interest rates as borrowing costs decrease and dividend-paying sectors become more attractive relative to falling bond yields.
• Treasuries (TLT): Treasuries will likely see increased demand, as lower interest rates drive up bond prices, making TLT appealing for stability.
• Gold (GLD): Lower interest rates reduce the opportunity cost of holding non-yielding assets like gold, which tends to appreciate during inflationary or uncertain periods.

These sectors provide a counterbalance to the volatility in the tech sector, reducing risk while offering stable returns.

Portfolio adjustments: selling stocks to fund options purchases

To fund the options purchases, we will sell 25% of each stock in the portfolio. This raises the necessary $35,195 to allocate towards the selected ETFs:

Specific orders for each ETF:

Now that we’ve raised the capital, here’s how we’ll use it to buy long-term options (LEAPS) on the selected ETFs:

• Selected option: Jan 2026 $66 strike call
• Price (ask): $15.35
• Number of contracts: 6 contracts
• Total cost: 6 × $1,535 = $9,210
  

• Selected option: Jan 2026 $38 strike call
• Price (ask): $8.60
• Number of contracts: 9 contracts
• Total cost: 9 × $860 = $7,740

• Selected option: Jan 2026 $87 strike call
• Price (ask): $16.20
• Number of contracts: 6 contracts
• Total cost: 6 × $1,620 = $9,720

• Selected option: Jan 2026 $220 strike call
• Price (ask): $33.70
• Number of contracts: 2 contracts
• Total cost: 2 × $3,370 = $6,740

Why January 2026 expiry and an 0.80 delta strike?

Expiry: January 2026

The January 2026 expiration date was chosen to give the options plenty of time to maturity. By selecting an expiry more than two years away, we reduce the risk associated with time decay (the gradual loss of an option's value as it approaches expiration). With this longer timeframe, we give the underlying assets room to move in our favor, allowing more flexibility in timing without the pressure of a near-term expiry.

• Time decay (Theta): Time decay accelerates as the expiration date approaches, but with LEAPS, this effect is minimized because there’s more time for the underlying asset to reach or exceed the strike price. The longer the duration, the slower the time decay, giving you more value retention in your options.

Strike prices: targeting a delta around 0.80

We’ve chosen strike prices for the options that offer a delta close to 0.80. Delta measures how much the option’s price is expected to change for each $1 move in the underlying asset. An 0.80 delta means the option will move approximately $0.80 for every $1 movement in the underlying ETF.

• Why 0.80 delta?
  • Higher probability of being in-the-money: A delta of 0.80 suggests that the option is already deep in-the-money or close to it. This implies that the option has a higher probability of finishing in-the-money by the expiration date, which reduces risk compared to out-of-the-money options.
  • Better price movement correlation: Options with a higher delta behave more like the underlying asset, meaning they offer strong upside participation while still benefiting from the leverage of options. You participate in 80% of the underlying asset’s movement while committing far less capital than purchasing the ETF outright.
  • Less sensitivity to time decay: High-delta options are less affected by time decay than low-delta (out-of-the-money) options. This means the value of the option is more stable over time, even if the underlying asset price moves slowly.

By targeting options with an 0.80 delta and an expiration date in January 2026, this strategy seeks to balance risk and reward effectively. You get the benefit of leverage without excessive risk from time decay or volatility, and the underlying assets have plenty of time to perform as expected.

Understanding long-term options (LEAPS) and their risks

While LEAPS offer leverage and cost efficiency, they also come with risks:

• Time decay: Options lose value as they approach expiration, especially if the underlying asset doesn’t move as expected.
• Volatility risk: Changes in implied volatility can reduce the option’s value, even if the asset’s price remains stable.
• Leverage risk: LEAPS magnify gains and losses. If the underlying asset doesn’t perform, you could lose 100% of the premium paid.

To manage these risks, it’s important to diversify, monitor positions, and avoid over-leveraging.

Final portfolio view

After selling 25% of each stock to fund the purchase of LEAPS, here’s your updated portfolio, including both stock holdings and long-term options:

What do we learn from this diversification strategy?

By diversifying the portfolio, we’ve achieved several important objectives that go beyond simply reallocating assets:

1. Deconcentration of tech holdings:

   • Prior to diversification, the portfolio was heavily concentrated in big tech stocks, making it vulnerable to sector-specific volatility. By reallocating 25% into defensive sectors like utilities, real estate, treasuries, and gold, we’ve reduced reliance on tech and made the portfolio more balanced.
      

2. Increased market exposure through long-term options (LEAPS):

   • An added benefit of using long-term options is the ability to control a larger amount of assets while committing less capital upfront. While the initial investment was only $33,410, we’ve increased the portfolio's overall exposure to $241,583, significantly enhancing the potential upside during market gains.
   • However, it’s important to note that increased exposure also means increased risk. The use of leverage can amplify losses as well as gains, so it’s essential to ensure that this level of exposure aligns with your risk tolerance.
   • If this higher level of market exposure doesn’t fit your strategy, you can opt to purchase fewer contracts for the long-term options, reducing your exposure to better match your risk profile.
    

3. Less volatility and risk management:

   • By spreading exposure across multiple sectors, the portfolio is now less volatile. Defensive sectors, such as utilities and treasuries, tend to perform well during market downturns, providing stability if tech stocks experience a correction. The addition of gold also serves as a hedge against inflation and currency risk, offering further protection.
   • The diversified nature of the new portfolio helps to mitigate downturns in more volatile sectors like big tech, creating a smoother overall performance.

Flexibility in your approach

It’s important to emphasize that this case study serves as education/inspiration, and the strategy can be adapted to fit different goals and preferences:

• Adjust the percentage allocated: You could choose to diversify a smaller or larger portion of the portfolio, depending on your risk tolerance and market outlook.
• Choose different sectors: The sectors we chose—utilities, real estate, treasuries, and gold—are only one example. There are many other sectors and ETFs that could be used to diversify your portfolio.
• Scale over time: You don’t need to make big moves all at once. Investors can start small and gradually increase their diversification efforts over extended periods of time, adjusting as markets and personal circumstances change.

This strategy provides a template for reducing concentration risk, improving market exposure, and creating a more balanced, resilient portfolio in uncertain economic conditions. The options are endless, and the key is to tailor the approach to your specific goals and outlook.