In all kinds of investing and trading, including options, the market pays us to take risks. Every trade or investment has them. The secret to profitable investing or trading is in picking the kind and quantity of risk that we are willing to take.
Here are some of the principal kinds of risk embodied in various investments:
- Market risk – the chance that what you own will drop in value.
- Physical and security risk – the chance that the asset could be stolen or destroyed.
- Credit risk – the chance that someone who owes you money will not pay you back.
- Interest rate risk – the impact of interest rate changes.
- Reinvestment risk – the possibility of having the investment terminate earlier than planned, at a time when similar investments are not paying as well.
- Inflation Risk – the possibility that when your principal is returned to you, it will have dropped in purchasing power.
These risks apply to different types of assets in different degrees and they cannot all be avoided at the same time. For example:
If you kept all your money in cash in the freezer, you would not have any market, credit or reinvestment risk. You would, however, have an extreme amount of inflation risk as well as physical/security risk.
If you put that cash in the bank, you eliminate the physical/security risk (as long as you arrive at the bank with the cash without being robbed). You still have the inflation risk, which is now offset to a tiny degree by the small interest income.
Investments in government bonds have (presumably) no credit risk and no physical/security risk. If you keep them until maturity, there is also no market risk. But the amount of inflation risk is very high.
At the other end of the spectrum, stock-based assets have a higher average rate of return than cash or bonds. Historically, interest on short-term cash deposits has averaged around 4% and on bonds about 5%. The average return on the stock market is around 10%, which is higher than the 3% average rate of inflation. Stocks have no physical/security risk (unless we keep the stock certificates in the house). They are equity, not debt, so they don’t have specific credit risk
But stocks’ higher average rate of return comes with a very large amount of market risk. Over the past 150 years, investors who held stocks for more than twenty-five years or so always achieved a respectable return. But in any shorter period there was a chance of major “negative investment results.” In other words, losses, sometimes big ones.
Put and call options give investors and traders choices as to what type of risk they are willing to assume. Some investors use options to convert market risk into another type of risk that they find more palatable. Other investors and speculators can volunteer to take on the market risk that someone else wants to avoid in exchange for suitable compensation.
For example, say that we have a $210,858 portfolio of stocks. We’ll soon see why we picked this number. This has performed very nicely in recent years but now we are nervous. We are afraid (let’s say) that the market could turn and take away half of that value, as it did in 2000 and again in 2008. But we hate the idea of selling out and sitting in cash, in case the market does keep going up.
Put options can help here. A put option would give us the right to sell our stock at a specific price, even if its market price collapsed to a fraction of that.
On June 24, 2015, the Standard & Poor’s 500 Index stood at $2108.58, very near an all-time high. We decide that we would like to protect ourselves against a drop in the market of more than 10% from here, which would be below about 1900 on the S&P.
There were put options available on the S&P index at the 1900 strike price. Each option cost about $7500. Each is equivalent to 100 times the S&P index value. In this case, 100 times the $2108.58 index value is $210,858, just the amount of protection we need. Now you know why, while we were supposing, a portfolio worth this amount. If our portfolio was five times as big, we could just buy five puts, and so on.
What could happen here if we bought one of these puts?
Worst case – the stock market drops more than it did in 2000, more than 2008. It drops like 1929 when it lost over 90%. Our $210,000 portfolio is now worth just $21,000.
Our put option would now be extremely valuable. It would give us the right to sell what is now $21,000 worth of stock, for $190,000 (the 1900 strike times the 100 multiplier). That difference in market value of $190,000 less $21,000, or $169,000, would be the value of that put. Adding in the $21,000 remaining value of the stock itself, our net worth would now be $190,000.
This is certainly less than our total investment in this position. We committed $210,858 worth of stock, plus $7500 for the put option, for a total of $218,458. Our net worth, at $190,000, is now down about 13%.
But that is as bad as it can get. A 13% drop, in a -90% world, is not too bad. If you lost 50% in 2000 and/or in 2008, how much better off would you be today if you had been able to start over from a base of 87% instead of 50%?
Best case – the stock market continues on its merry way. It never drops and you never need the protection provided by the put. You have given up $7500, or about 3.5% of your original value, for protection that you didn’t use. You have traded a decrease in actual return for a large reduction in market risk. And your upside profit is still unlimited – it will just be $7500 less than it would have been without the put.
That kind of proposition would appeal to many gun-shy investors. If you are one of them, consider put options as protection.
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