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Avoiding Disaster with Portfolio Insurance
I was planning to write this article about how to graph the basic building blocks of an options position. However, several readers are concerned that we've seen the end of the bull market and that the bears may be waking up. They want to know how to protect their portfolios if the market does head south. Personally, I'm not convinced that the bull is dead, but it's certainly a fair question.
One of the reasons I enjoy options so much is that they are very flexible and can be utilized in so many different ways. Not only can we use them to make money with limited risk, generate an income stream, increase our leverage, or to speculate, but we can also use them to protect an equity portfolio that we already have. Kind of like an insurance policy.
I'll typically ask people if they have life insurance, homeowners insurance, health insurance, auto insurance, and get a lot of yes's. Then when I ask if they have any portfolio insurance, they look at me like I have 3 eyes. "You mean you can buy insurance on stocks?" Well, we're options traders, we know that you can. There are actually several ways to do it, but like everything else in life, there are advantages and disadvantages to each. Let's take a look.
For the purpose of our discussion, we're assuming that the portfolio we want to protect consists of several different long stocks of varying quantities.
The most obvious way to "insure" i.e. protect, a portfolio is to buy Puts on each of the stocks. For every stock in the portfolio, we would buy a corresponding number of Puts equal to the number of shares divided by 100. So if the portfolio consists of 1,800 shares of XYZ stock, then you would buy 18 Puts, etc. Several questions arise:
A) Which strike do I buy? Answer, that depends. How much risk are you willing to absorb? The difference between the stock price and the strike price you buy could be considered the insurance "deductible." That's the amount that the stock can decrease before this Put insurance kicks in. Let's say we're willing to absorb the first 10% drop in our stock. So if the stock is currently at $100, we're willing to let it drop to $90; but then we want protection. Of course the amount of the deductible, $10 in this example, will be a determinant in how much this insurance is going to cost as we will soon see. Less insurance (higher deductible) lower cost, more insurance (smaller deductible) greater cost.
B) How far out do I go, which expiration month makes the most sense? Unless we always want to have insurance (remember, that costs money) we'll probably take it off when we feel more comfortable about the market in general. For now, let's assume that we think that the market will be in a general decline for the next year. We'd like a relatively good prediction since we want the insurance when we need it, but on the other hand, we don't want to pay for it when we don't need it. So we try to be accurate, but it's not totally critical, since we can make adjustments as our predictions change.
C) What's it going to cost? Crunching some numbers, I determined that with a stock trading at $100, the $90 strike Put expiring in 3 months will cost about $175 (assuming 30% volatility), 6 months cost $330, and 1 year of protection costs $546. I also calculated that a 2 year Put would cost approximately $800. Now I have several choices, I can buy 3 months and then renew 3 times. Assuming nothing changes, that will cost me $175 x 4 = $700. Alternatively, I can buy 6 months twice for $660, or just buy the 1 year Put for $546. That's about 5.5% of the amount ($100) we're protecting, it's pretty expensive! What makes the most sense to me would be to buy the 2 year Put for $800, and then at the end of 1 year sell it back for $546. This provides a year of protection for a net cost of $254, or 2.5%.
This method of protection works well, but it does require some watching and rebalancing from time to time. As the stock goes up the deductible increases and we if we want to stick with a 10% deductible then we will probably roll the Puts to a higher strike, which will cost us some premium dollars. This increased premium will be offset by the increase in the stock. Also, keep in mind why we bought the Puts in the first place - to protect us from the stock falling. If it increases and we don't get to use our insurance, that's a good thing!
For those who aren't keen on paying for insurance, there are a few alternatives to finance the purchase of the Put. We can sell a further out of the money Put. In the example above we bought the $90 strike. We can then sell the $70 strike Put 1 year out for about $100, lowering the cost to about 1.5%. People do this, but in my opinion, it's a disaster waiting to happen. You have protection from $90 down to $70, but remember we're predicting a bear market, and if the market really gets clobbered, you start losing on the stock below $70, because that short Put is going to eliminate the benefit of the $90 long Put. My feeling is you're better off not selling the $70 Put and being able to sleep at night.
There is something else that you might want to consider, and that is to sell some out of the money Calls to finance the Put. That's actually called a collar, and I'll discuss it in greater detail in the regular series of articles. In this case we're going to want to take advantage of the faster premium decay of short versus longer term options. So with the stock at $100, the 3 month $120 strike Call can be sold for about $100. Do that 3 more times for a total of $400, and we've lowered the cost of our insurance to negative $146! Am I dreaming, or is something wrong here? Neither! What's happening is that we're giving up the upside potential on the stock. In this case, that's probably okay. Again, remember, we predicted a down market. So if we were wrong and the stock goes up past $120, we'll be assigned and the stock will be called away. However, we'll make the $20 (from $100 to $120), we'll keep the Call premium, and we'll salvage whatever we can on the Put. All in all, not so bad.
Another approach to insuring your portfolio requires that you first determine what your portfolio looks like. By that I mean is it represented by the S&P 500, the DOW, the NASDAQ, the Russell 2000, etc., or some combination, like 60% DOW and 40% NASDAQ? If so, you may want to buy Puts on the appropriate index fund, i.e. SPX, DIA, QQQQ, IWM, etc., or a combination. The theory here is that the index Puts will be cheaper than Puts on individual stocks. The problem is that you then run into a tracking error to the extent the index (or combination) is different than the portfolio. I advise you to crunch some numbers to see if this type of insurance would be appropriate for your portfolio.
Finally, there are still other more sophisticated and involved approaches to insuring a portfolio such as using futures and/or options on the VIX. New products are constantly being designed and approved to make it easier to protect a portfolio against many negative contingencies. Of course, they don't come without a price. We must be vigilant and find the method that works best for our own given set of circumstances. This is not a case of one size fits all.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!