When I am asked whether people should learn options, I ask them the following questions:
Do you have car insurance?
Do you have homeowner’s insurance?
Do you have life insurance?
Of course, most people say yes. But when I ask who has insurance for their IRA or who has stock insurance, people look at me with a quizzical, “What are you talking about?” look on their faces.
Then, after the concept of insuring an IRA sinks in, they ask…”Really? Can you really insure an IRA?” The answer is: absolutely yes. Just don’t try calling State Farm tomorrow morning and asking for their IRA insurance policy department. But yes, you can, for all intents and purposes, insure an IRA, or most stock positions for that matter.
Why Have Insurance?
First, let’s define the concept of insurance. Insurance allows you to protect an asset against loss by being compensated if the asset loses value.
Let’s take homeowners insurance as an example. If you own a house and it burned to the ground, what would you get? Assuming the insurance policy is paid in full, hasn’t expired and you didn’t start the fire, you would receive a check for the insured value of the home. You would recoup your financial losses.
Now, what if, in 2008 when the market dropped 50 percent and thus most mutual funds lost about half their value too, you had the ability to recoup your losses? Wouldn’t that be nice? After all, making money is great, but not losing money is just as important!!
How Do You Insure an IRA?
Buying a put option is an options strategy that will act like an insurance policy.
We can buy a put option on the SPY, which is the Exchange Traded Fund (ETF), that tracks the S&P 500. That put option will then increase in value as the S&P drops, offsetting the loss you’re taking on the SPY ETF.
Think about this…in any given year, approximately 80-85 percent of mutual funds underperform the S&P 500, meaning the return they deliver is less than the return of the index itself. And given that most–if not all–of the stocks in most IRAs are in the S&P 500, it’s a safe bet that if the S&P drops 50 percent, most mutual funds will drop by at least that much.
For example, if you owned the Fidelity Magellan Fund and bought a put option on the ETF that tracks the index, and the index dropped 50 percent, the put option would greatly increase in value, offsetting the loss that the fund incurred.
Isn’t That the Concept of Insurance…Offsetting a Loss?
Here’s another good example: In October 2007, the Fidelity Magellan Fund was trading around $105 per share. In March 2009, it was trading at $36 per share—that’s a drop of 65 percent! What if you were still able to sell your shares at $105 after the drop, when the fund is trading at $36 a share? It would be like being able to sell a BMW for the $35,000 you originally paid for it, after it was totaled in a crash!
Similarly, buying a put option on a stock or ETF gives you the right to sell that asset at a higher price in the future, no matter how low the price drops.
Options are derivatives of an asset, and they derive their price, in part, from the asset. A put option is a negatively correlated option, meaning the value of a put option will increase as the value of the asset declines.
If you understand the concept of insurance as it relates to cars, boats, houses and even lives, buying put options on a stock, or IRA position, is conceptually the same thing. The value of the insurance will increase as the value of what’s being insured drops.
So, while the market tanked 50 percent in 2008 and 2009, with options you would have been able to offset most of that loss.
And given that the market is up approximately 250 percent since 2009, think where your bottom line would be now if you hadn’t taken a 50 percent loss on the way down because you had the foresight to insure your portfolio?
What Types of IRAs Can Be Insured?
To insure your portfolio, you would need to have a self-directed IRA–a retirement account that puts you in charge of the trading and investing. If your standard IRA is handled by a broker that offers options trading, it could also qualify. Most brokers don’t offer options and if they do you need approval from them to trade in the account. There are many reputable brokerages that allow trading options in a self-directed IRA, including Trade Station, Think or Swim, Options Express and TD Ameritrade.
If you were managing your own retirement account in a self-directed IRA, you would buy the appropriate Put Option, for the appropriate length of time, to protect your assets. Again, if you had your account professionally managed, you could instruct the broker or advisor to purchase the puts in your account.
Purchasing the Right Policy at the Right Time
However, as with many insurance policies, if you purchase the wrong policy you may not have the coverage you think you have. If you go online and only spend a few minutes searching for a policy, you may think you have purchased the insurance you need only to find out you’re not covered when you need it most. And unfortunately, it always seems that it’s when you need the insurance most, that you find out you don’t have the appropriate coverage.
Put options can work out the same way. If you bought the right amount of options, with the right expiration dates and strike prices, you could be fully protected against a market crash. However, just like discovering you don’t have flood insurance until after a hurricane floods your house, you’d hate to find out you bought the wrong options, or the wrong expiration date, or just not enough contracts to protect your account.
Options, like insurance, aren’t free; they need to be purchased but cheaper isn’t always better. Also, just like insurance, options have an expiration date. You need to not only purchase the right option, for the right amount of protection, but for the correct length of time as well.
The best time to buy insurance is before the insurance company knows you need it. With the markets at all-time highs, there is very little fear in the markets right now. As this historic bull market continues along, now is the best time to discuss options with your broker or to learn to trade them in your own account for yourself.