Sunday, January 28, 2018

Insuring against the Melt-Down

Yes the good times are rolling. How long will the Melt-Up last? No idea. 6 months; 18 months?  I do know that the higher the markets go, the higher the risk. Contrary to the beliefs of many, risk of reduced profits and losses increases with market pricing. Also, the opposite is true: the lower market prices have fallen the less risk for even lower prices.  This is obvious, except to many investors – especially retail investors who always seem to get involved in expensive markets out of fear of missing the boat.  Bad luck if you just bought in, you probably have missed the boat or just got in when things got wobbly in today’s bull market.

Stock investing is about volatility – a word many have recently forgotten.  Still remember the pain from 2008-2009? Ouch it still hurts but really if you had held on in those days, you would have tripled your portfolio value from portfolio levels at the through of that market and you would have even made respectable gains compared to the peaks of 2007 – possibly with the exception of investors that stuck to Canadian markets. That is where international diversification comes in and I have written already quite a bit about that in previous posts. 
Basically, we are talking about market volatility that makes us sick in the stomach, but it also provides the opportunity to buy stock on the cheap. Wouldn’t it be nice if you had a pile of cash near the bottom of a market while you never sold a single stock during that downturn? Well, as said many times before, volatility is an illusion if you consider that long-term stock returns are 6 or 7% plus inflation using Jeremy Siegel’s research. However, wouldn’t it be nice if, like many professional investors, we could generate a lot of cash from market volatility?  Officially that is called portfolio hedging or portfolio insurance.  And as all insurance it is not free. You will have to pay insurance premium and that will lower your overall portfolio performance. But what if that could also result in a lot of cash and a more stable portfolio value?  Hmmm, you can do a lot to hedge your portfolio’s stability like building a cash hoard or accumulate gold or buying bonds that hopefully go up during the next crash. Diversification of your assets may help. Yet even when holding only quality stocks, during bear markets your portfolios will go still down but maybe not by as much as the overall market. 
So, we are insuring against volatility and now we are trying to reduce that volatility and building cash to create an opportunity to buy even more stock on sale. Say you own a house worth $100,000 (well that would be a shack). Now somebody knocks on your door. You open the door and a shady guy stands there and says: “I will buy your house or better your shack for $150,000 at the end of next year." You know, with the current state of real estate there is a good chance it will be worth that much; but what if the market actually drops because of all those new mortgage rules and foreign ownership taxes?   Hmmm you think to yourself. That offer is $50,000 above today’s prices and I am not sleeping well these nights because of all the profits I already have made on paper.  You look at the shady sucker and get a brilliant idea. “You know what fellow, I might lose out on a lot of profit. Last year my shack went up $50,000 and this year the real estate board forecasts that it could double again!  I’ll sell you the place for $150,000 a year from now if you pay me today $10,000.” The shady character says, "$10,000?? That’s outrageous because if the market doesn’t go up to $150,000 I lose all $10,000. What if I paid you $2,500?”  You: "But you have an excellent chance, according to the real estate board, to turn around and sell my shack for $200,000!” You haggle all night at the door and agree on a $5,000 call option premium.  Because that is what you are doing. You sell to someone the right to buy something (your shack) anytime over the next year (the option term) for a certain price (the strike price) for a premium of $5000. The deal expires at the end of the year, i.e. the expiration date. If you do the same with shares in a company this is a ‘call option’. If you do it with oil or grain or sugar it is called a ‘futures contract’.
If you are afraid for the value of your shack to fall over the next year; you could have bought from someone the right to sell the Shack for a pre-set price (strike Price) anytime during the year (term of the option) for a premium, of say $500. This is called a ‘put option’.  Selling call or put options is a low risk way of earning income (premiums) on shares you own or wish to own.  You can also speculate in options, which is a high-risk strategy a bit like playing the casino. But the real purpose of options is to mitigate risk.  The farmer BUYS a put option?  Well if the price of the harvest falls below the strike price, the put option buyer MUST buy the harvest at the strike price because that is what the farmer paid him the premium for. The farmer bought himself or herself (we have to be non-sexist) insurance to guarantee the sell price for the upcoming harvest. You can insure yourself against a falling stock market by buying put options for your portfolio or for parts there of. 
Let’s assume that you own a basket of U.S. stocks and the market is going higher and higher. Rather than buying a put option (insurance) for each stock you own, you buy put options for the entire market as represented by the Dow Jones SPDR ETF (symbol DIA-N) currently priced at $260 per share (that saves on commission and makes it all simpler).  Options are not sold on a per share basis but on a full lot basis, i.e. 100 shares.  An option contract is ALWAYS for 100 shares even though the option price or premium is listed on a per share basis.  So, if you buy an option for DIA_N priced at an option premium of $12.70 per share; the price for the contract is 100x $12.70 or $1270.

Now, you may ask what kind of an option do I get for $12.70 per share?  Well, the option market sets the option price or premium kind of like an auction. When I last checked the market, I wanted to buy insurance (Put options) for 100 DIA-N shares at today’s share price of $260.  Thus, the strike price for the option is $260; if the price of the DIA-N falls to $250 then, because I have the right to sell those shares to the seller of the put option for $260, the option’s value is $10 per share; the difference between strike price and market price is called the option’s implicit value. The implicit value changes during the term of the option.  I will also pay premium depending on the length of the term of the insurance.  Because what if during the insurance term the DIA-N price fell further to say $200?  Then at the end of the term you lost even more $260 minus $200; the first $10 and another $50. $60 would be the new intrinsic option premium.  Thus, the longer the term of the insurance the higher the risk for the insurance seller and thus the higher the premium for his put option.  The difference between the strike price and the actual market price of the DIA-N is called the IMPLICIT value of the option and the extra premium charged for the time that the insurance lasts is called the TIME value of the option.  
The higher the risk the seller perceives, the higher the premium. If there is, in the eyes of the seller, no chance the DIA-N falls all the way to $250 then he/she would sell at a much lower premium than if the seller was sure that the DIA-N would within the year fall indeed to $250 or worse to $200. This risk estimation (implied volatility) is also build into the option premium. Thus, the total option premium comprises Intrinsic  Value plus Time Value plus Implied Volatility.  After all, you may want to buy insurance, but the seller of that insurance is not necessarily an imbecile. He wants to make money too. He may just have a different outlook on the market than you and wants to get paid for the risks he takes.
Who cares why somebody sells the insurance, as long as you are covered!  But you must understand at least a bit where the seller comes from to know whether you pay a decent insurance premium. So what do you pay today for an put option with strike price of $260 for the DIA-N that expires in about a year?  Well, I checked my on-line discount brokerage where I have permission to buy and sell options. The premium is $12.70 so that means I can buy an put option contract for 100 shares for $1270.  This ensures that 100 shares now trading at 100 x $260 = $26,000 won’t fall in value because if they do, the option seller will still buy them from me for $260 per share anyway.
Aren’t you smart?  No way of losing.  What if I don’t want to lose but also want to make money in such a falling market?  Say the DIA-N falls to $200 but I want my $26,000 in U.S. stock portfolio to increase in value by 10% to $28,600 regardless, can I do that?  Sure, you can – just buy more put options. At option expiry a $260 DIA-N is worth $200 or the option pays out $60 per option.  To earn $2,600 in profit you must buy $2600/60 is another 43.3 options or pay an additional premium of 43.3 x 12.70 = $550 dollars. Wow… How can I lose?  Well, what if the market doesn’t go down?
If the market goes up rather than down will you lose your insurance premium. You paid $1270 plus an optional $550 in premium and because the market went up you didn’t need the insurance and the options are, like any insurance, worthless at expiration. Say the market went up by 10% instead of falling. Your shares are now worth $28,600 but you paid in premium $1820 dollars!  Your portfolio has now only increased to $28,600 minus $1820 or $26,780. That is not a 10% but a 3% return. That is the price of avoiding volatility! And the longer you have your insurance the more premium you pay.

You are now protected on the downside, but your upside is limited.  Just like the farmer selling his/her harvest you are ensured the minimum price of $26,000 worth of investments. Which is sweet during a down turn and even provides you cash.  With the decline in market value, the value of your options go up and you do not want to sell your portfolio. No Problem, you just sell the put options near expiry for close to the implicit value plus maybe a bit of remaining time value and implicit volatility premium. That way you still own all your shares, even collected dividends and you converted the options in cash which you could use to buy more shares near the bottom of the market. And when the market recovers during the next bull, wow you’d look like a genius!
My strategy is to buy my insurance in chunks, so I may buy a bit now at prevailing market valuations.  Then six months from now if the market went up, insurance for DIA-N with a strike price of $260 would be a lot cheaper based on intrinsic  value and a shorter expiry term i.e. time value.  Or I could buy options at the then prevailing market value of DIA-N shares and thus lock-in some of the profits made on paper over the last 6 months. I also could extend the insurance term by buying options that expire 12 months from then instead of the remaining 6 months expiry of earlier bought options. Or... I could do both; increase the strike price and the option term.  The combination of choices is endless so don’t get confused because that may create more risk than you bargained for. 

This was quite a complex posting with many ins-and-outs. The next blog will show you the numbers in spreadsheet of our simple scenario of buying $26,000 portfolio insurance in the form of 1 contract of DIA-N put options at a $260 strike price expiring in December 2018 for $1270 or a price of $12.70 per option.

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