Sunday, February 4, 2018

‘Put-option’ insurance protection for the Melt-Down

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Earlier we discussed that portfolio insurance may provide you cash during a downturn without having to sell off parts of your portfolio.  You get this ‘insurance’ through buying a put option. In case of protecting your U.S. portfolio, rather than buying put options of every single U.S. stock holding you own, it is probably more affordable to buy a put option on say a Dow Jones index ETF. Example:  Dow Jones SPDR (pronounced [spider]) ETF.  This ETF trades around a share price of $260 (all dollars in this post are U.S. dollars).  You can buy a ‘Put’ option for around $12.70 per share or $1270 per contract (which is for 100 shares). So you could insure a portfolio worth  $26,000 (100 ETF shares) by purchasing 1 put-contract for $12,70 per share or $1270 per contract.  If the share price fell by 10% to $234, the value of your option would increase by (260-234 = $26 per option).  This increase is also referred to as the option’s intrinsic value or premium. Thus, the value of the entire contract would increase by 100 x 26 = $2600. 

If your portfolio was diversified and reflected the exact share price of the Dow Jones, then it would have fallen from $26,000 to $23,400 and the increased put option contract value $2,600 would have covered the loss exactly. Eh…. But we also paid for the contract $1,270 in premium, so the profit on the options is NOT $2600 but $1330!. We will get back to that.

Say the market fell not 10% but 50%!  Then your share value would have fallen to $130 and the option contract would have an intrinsic premium of $260-130 = $130 per share or 100x$130 = $13,000 per contract. With the contract’s original purchase price still being $1270.  So with a 10% fall the premium would have reduced option profits by nearly 50% but with the 50% loss it reduced your option profits by less than 10%.  Consider the $1270 your 'deductible'!
But this 'put option' insurance deductible is kind of strange. Because you may be able to earn it back in part or better, make a bit of a profit on it. You see, the $1270 represents the 'time value'  of our insurance.  You can cash-in your option during any time of its term by selling your put option. You could sell or exercise it on expiry and you would only receive the intrinsic premium; in our 10% decline example that would be $2600 and since you paid $1270 in premium you’d ‘only’ made $1330.  But what if the crash happened only 2 months into the 12-month term of the option (which expires in January 18, 2019)?  If the market would fall even further during the remainder of the option term, it would increase even more in intrinsic value. Thus the option has remaining time value!  Even better, since the market fell so dramatically (increased market volatility is the official term), other investors are now willing to pay nearly anything for insurance – that is called the implied volatility premium of the option.
So, if you think you are near the bottom of the market and you’d want to start buying stock again, you can sell your options for its intrinsic premium plus the remaining time value of the option and, depending on the market’s fear level, the implied volatility premium. Thus, if you sold you’d receive $2600 plus extra premium which may well be a lot more than the $12.70 you originally paid!  Say your remaining time value and implied volatility adds another $15 value to your total option premium and you’d sold your put options 2 months into the term at a time of significant market despair for a total of $26 plus $15 = $41 dollars.  That would be a total of $41 dollar or a profit of 100 x $41 = $4,100! That is the beauty of this kind of ‘put-option’ insurance: your ‘deductible’ may become part of the profit!
Suppose you have an $100,000 portfolio in U.S. stocks. With the Dow Jones decline of 10%, you’d lost $10,000 so now comes the high school question: ‘How many apples… eh contracts should you have bought to cover that loss?  Answer:  $10,000 divided by $1330 is 7.52 contracts.  So, you need to buy 7 or 8 contracts (you cannot buy fractional contracts) to protect your entire portfolio. That is nearly 10% ($10,000) premium if you’d want to protect for even a small correction of 10%.  But we are only interested in a crash of 30% or worse. If that happened during the term of your insurance, you’d only needed around 4 contracts (maybe 5) and your premium would be around $5,000 or 5% of your portfolio value. And don’t forget the potential of the ‘profitable deductible’! However, the latter is purely speculative and at this point, I don’t account for such a windfall.

Before moving on, you may wonder if you can only break-even when buying 'put-option' insurance. Not at all. This is what makes option strategies so interesting - you can design your option strategies to do nearly anything short of making good coffee. Although you could use the profits to buy a very good coffee maker machine! 

On the spreadsheet above, I created a scenario that not only have your portfolio break-even but it also makes a 10% profit! But realize, none of this is risk free and the more you bet against the market the more you risk!
Buying ‘put-option’ insurance is not a one way street. Because if the market doesn’t fall, the premium you paid is gone! Say the market rose 10% over the term of the option. That is your portfolio rose by 10% from $26,000 to $28,600? Well, your total return would suffer because out of the $2,600 profit you will pay $1,270 premium and thus your return is only 5%.  On the other hand, you’d probably didn’t only get $2,600 appreciation but also received another 2.6% in dividend yield, so your profit would be capped at around 7.5% compared to nothing if you had not participated in this market. By now, you must get a good idea about what ‘put-option’ insurance is all about. Another post will follow to discuss the limited upside of such an insured portfolio.

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