OG grabs the reins for his usual Thursday rant!
This week, the US equity markets quietly reached a “four-year high,” prompting many (including me) to question the validity of this recent rally. The market is up nearly 26% over the past 12 months. During this same time we’ve had:
– the dreaded “downgrade” of the US debt,
– the Eurocrisis, Spain, Italy, Ireland, and of course Greek near-defaults
yet most people won’t feel much richer if you ask them “how’s the market doing?”.
As a practicing advisor, whenever I hear “lowest ever” or “best ever” or “all-time” anything, I automatically consider the inverse. As CNBC, Fox News, CNN and Bloomberg keep us glued to their networks with fear and greed, I’m left wondering…
So I’ve begun thinking about protection strategies.
Today, lets talk about about a powerful tool: the Put Option.
Wait! Don’t run away! It’s actually a good way to shelter your investments AND it isn’t nearly as difficult as you might imagine. While many option strategies are pure speculation, this one is designed for the conservative investor…the one who wants to insure everything.
Let’s say the S&P 500 closed at 1420. We can go out and buy an S&P 500 index fund that mimics the index, (ticker – SPY). If you look up SPY on any finance site you’ll see today’s closing price and you’ll notice it trades at 1/10th of the actual index’s price. Since we assumed the S&P closed at 1420, the SPY would close at 142.
Now let’s further assume that you’re okay with day-to-day volatility of a few percent here and there, but you want to prevent the catastrophic loss of 20% or more over a few trading days – the so called “Black Swan” event. What we want to do then is to protect our current account against future loss, or said another way, we want “the ability (or option!) to sell at today’s prices sometime in the future.”
Wouldn’t it be nice to say “I want a do-over” if the market collapses and our funds slide?
The tool that accomplishes this is called a put option and it allows us to do exactly that. We have to pay for this option, so let’s explore what that would cost. It might not be worth the price.
If we pull up January 13 Put Options for $130, we’ll see that we can buy those for $3. January 13 Put Option means that we can sell the options for $130 anytime we want between now and the third Friday in January. This represents about a 9.5% decline from today’s prices and the $3 price per contract means that we’ll lose another 2% to cover the investment.
Here’s how I figure all this out
1) I determine the amount at risk. There are many risks, but in this case we’re talking about stock market risk. If your portfolio is $100,000 and you have 50% in stocks, your amount at risk is $50,000.
2) Next, I decide how much downside I’m comfortable accepting. As we discussed, a 10% decline is tolerable, but a 20% loss is catastrophic. I decide to insure everything below a 10% loss.
(side note – why don’t I just insure it for the current price? The cost to do this is nearly always huge. It’s like insuring your house….having a deductible of 10% is much cheaper than insuring every instance.)
3) Next, I’ll find prices. Using today’s numbers, it would cost me $3 per share to cover everything below a 10% loss.
4) Fourth, I do the math, which isn’t difficult. Don’t let it scare you. My amount at risk is $50,000 divided by $142 (todays SPY price) is 352 hypothetical shares of SPY. Although options are priced per share, they’re purchased per 100 shares. I need to buy four contracts to insure all my amount at risk.
4 (contracts) x $3 x 100 = $1,200 or roughly 2.4%.
5) Now I make my decision, weighing each outcome. Lets list them:
Outcome #1 – the market stays flat or increases through January 2013. If this happens, I’ll forfeit the entire $1,200 paid for the option contracts, but would’ve had the piece of mind. Basically, an automatic 2.4% loss for insurance that I didn’t use.
Outcome #2 – The market declines, but less than 10%. In this scenario, because of my “deductible” amount, I also lose the entire amount invested in the option contracts. Insurance that I didn’t use.
Outcome #3 – The market declines greater than 10%. In this scenario, my total loss is limited to just 10%. If the market goes down 20% over the next several months, I cash in my option contracts to recoup some of those losses at anytime I want through January 2013.
6) Finally, I decide whether to pull the trigger. If so, let’s try to find an “up” day to do the trade to lower your cost a little. If not, I have to be comfortable with my decision and move on.
So now it’s your turn. What outcome would you choose? Would you buy the insurance? What do you do when you start thinking about “protecting” some gains?
Photo: Stock Market Bull – thetaxhaven
Isn’t it the case in all election years that market takes a dip prior to election?
Timing the market and investing in it in general is a pain the butt! lol.
This is a very interesting concept but I’m not really sure I’d be that concerned. If I was fine with a 2.4% loss then I’d just go invest my money in a CD right now or in a money market earning .8%. Also, if I couldn’t afford to lose the money as I was nearing retirement then I might not be in the market at all (or would have less exposure).
I have no idea what the market will do over the next 6 months, but I don’t think it’s going to drop more than 20%. I’d say 10 is a possibility though.
Good point, Jason. But that brings up a question: when would you take the money out of the CD or money market? You’ll have to be right twice on that call (something I’m not excited about). The put option still gives me the upside if the market climbs. Because I’m dumb and don’t know what the market will do tomorrow, the insurance works better for me.
I would take the put option. $1200 would buy me the peace of mind in case the market drops considerably more than I can tolerate (my tolerance is based on the purpose of my investment portfolio). I’m to minimize my loss. Plus, I will make up the $1200 over time as the market rebounds. This is the S&P 500 index and I have wouldn’t need my money for quite awhile. Plus, the other half would be invested in other assets and sectors.
Right now this is a rally. It’s hype, but it give a good sentimmental sign of how investors feel about the market. And when there’s a rally, there’ll be a decline. Since the recession, market performanace has increased.
So, if I did do a put option, I’m purchasing it for the peace of mind for this particular example. 🙂
I like how you get me to think…lol.
I’m thinking that the markets will continue to flounder with a vague upward trend. More often than not (+85% of the time) there is a rally after the US presidential elections.
So don’t be surprised if you find me on the other side of your PUTS!
I’ll take your money!
I wound up buying a tonne of stuff around this time last year. There were a few days of wild drops and looking at what I was interested in, I decided the current market prices were just too low.
It’s taken some time for the markets to digest the EU debt situation, but it looks like nobody wants to be held responsible for sinking the good ship EUR. It will come around, but it’s going to take them 10-15 years. Which considering the age of the economies we’re talking about, this 10-15 year time frame is SHORT TERM in the grand scheme of things.
So my $0.02 worth: long, slow periods of seemingly directionless movement with an agonizingly slow upward trend, and the occasional week or three of panic.
I like to ask myself, “What Would Cramer Do?”… then do the opposite.
How did you pick January in the above example? Oh, I took a look at the contracts, but as I post this the price on the $129 is pretty competitive with the $128. Of course, I had the benefit of posting this post-market open, heh.
I am in it for the long haul, plus two out of three scenarios give u losses thus i’ll pass on the contracts. I would just buy more shares if and when the market falls and realize a greater increase on the next upswing. I currently protect myself by having bonds.
I have never even heard of this. I definitely have some research to do. Thanks for the idea.
Options are a bit of a mind-job at first… There are many many scenarios as to what you could use and why.
But once the light comes on, then you can use it to enhance your returns on stocks you already love. (by writing “covered calls”) Or buy SELLING “naked PUTS” to buy MORE of what you like IF it pulls back.
I hadn’t heard of this or if I had didn’t pay attention. If I needed my money withing the next few years, that would be tempting. Right now, I am not to concerned by ups and downs. Maybe I should be more concerned, but stocks have never really scared me.
Nope. I’m with you, Kim. If you don’t need the money any time soon, it’s best to use this as an opportunity, right? However, people who want or need to protect the bottom line can do so with this tool that many don’t use because it seems scary.
That’s why I like using “naked” or “cash-covered” PUTS to add to my positions.
I like it even better if the contract expires without the shares being assigned to me!
Just to clarify, this only works for single stocks outside of a retirement account or am I missing something?
It all depends on your 401k/IRA Broker. Some let you trade options, for example I can trade options in my Roth through TDameritrade but I can’t trade them through my 401k with ING. As for what stock/etf you decide to trade the options on, I would say the author is talking about protecting his investment in a mutual fund that tracks the S&P or he could be talking about the etf SPY. Either way he would be protecting his investment by buying puts on the SPY.
Joe, did you buy the puts? I really like how clearly you explained the concepts. I like the idea of insurance (protective puts) for conservative investors. The options on indexes are preferable to those on individual stocks.
I have never been very good at timing the stock market. I keep investing (dollar cost averaging) into the market. Over time, I am shifting my investments to less volatile investments. Funny, my asset allocation is set up to weather the volatility anyway. I still want growth in retirement because most of my retirement income will be from fixed sources such as Social Security and a pension. My IRA will supplement those earnings.
We don’t even try to time it. That’s why OG likes these protective option strategies, I think. It allows him to put defensive measures in place without having to bet which was it’s going to go.
Thanks for the clear example OG! I like the concept, but what has held me back is applying for the special account to trade options. Isn’t it because options are riskier?
Great question, Buck! Options CAN BE riskier, but this particular strategy is a protective one and is meant to lower the volatility in your portfolio. That said, you might buy this option and the market goes the opposite way, making the “insurance” never trigger…just like with your car insurance if you don’t have an accident.
Great theory, but I’d use put option only if I think that my investment is prone to cyclical ups and downs, or if it can get hit due to earnings(may partially due to its exposure in Europe etc.). On the contrary, I keep buying great companies like Apple on every dip.
We don’t worry as much about the investment as we do the timeframe. If you’re stuck with a position you’ll need to get out of soon and shouldn’t have had stock in the first place, this is a great way to lower the volatility. The way you’re playing, Shilpan, is a more aggressive use of options than this, I think, like writing covered calls.
Currently, I am “long” with most of my investments (expecting prices to go up). But I did buy out of the money puts, just to get some pocket money when reality turns out different. With volatility low (VIX being low), puts were relatively cheap. Now I will be happy any way: or markets go up and my investments pay off or I have some pocket money that will help me to spend time and show patience till my investments do materialize.
Good advice. Why not take it a step further and sell a covered call to pay for your put option?