Using put options to insure portfolio against losses?

fabsaver

I've recently been reading The Autopilot Portfolio downloaded free from Amazon a while ago.

The book is clearly aimed at the US reader but some of the investment principles are valid here too. Part of the strategy is investing in low cost index tracker funds and then insuring those funds against losses from a market crash.

The 'insurance' refers to the use of put options to protect against a particular index falling. In the example given the S&P 500 index is trading at $1200 and the investor buys an option to sell that index in one year at $1000. If the market falls by more than 20% the option can be exercised and losses will be limited.

I'm wondering if these products can be bought by private investors in the uk too? I assume some sort of specialist broker account would be needed? I've no idea how much they cost or if it would be worth it.

With the markets so high at the moment the idea of some kind of 'insurance' is appealing.

bowlhead99

There are all kinds of financial derivatives that can be used to hedge different types of events.

An easy way to do it as a retail investor is using a spreadbet provider such as IG.com, you could buy an option as you describe.

For example, FTSE100 is currently at 7135 and the option price to buy a a put option for 15 September 2017 at 6400 is is 100.9. So you could buy that option at £10 a point, for £1009.

Then fast forward seven months. Say the FTSE is at 6800, it has gone down over 300 points from today's level, but an option to sell the FTSE at 6400 when the FTSE is at 6800, is worthless, so you don't get anything for your £1009 outlay.

But if the FTSE is at 6350, your option to sell £10 a point at 6400 when the market is trading at 6350 is worth 50 points x £10 = 500. Not as much as the £1009 you paid for the option, so you lose money, but not a total loss.

If the FTSE is at 6000, the option to sell £10 a point at 6400 is very nice. 400 points at a tenner a point is £4000, a lot more than the £1009 you paid. And every further point fall (e.g. to 5999 instead of 6000) gets you another tenner, so if you had £60k of FTSE assets at that point, you would be making a tenner on the option for every tenner you lost 'in real life' on your portfolio value.

If the FTSE is at 5000, the option to sell £10 a point at 6400 is great, because that's £14,000, dwarfing your stake. If you'd had £70k of real investment in the FTSE100 today, you would have been disappointed that it had lost £20k+ as the market fell to 5000 over the seven months, but the £14k gain on the option would offset it somewhat.

The options are tradeable, so you don't need to wait the seven months. If you pay £1009 for an option, and then change your mind, you could sell it at £889 today. The big spread in the middle is how someone like IG makes their money. But for example if the market becomes choppy and volatile and heads quickly down towards the 6400 level, having an option that pays out under 6400 is going to be much more of a prized asset, so someone would pay you much more than £889 for it, and you don't need to hold on to see whether or not the market actually got to that low level.

However, as we saw, it can be expensive to put in place. It can be tricky to know where to start. In the example above, the market could fall by 785 points, over 10%, from 7135 now to 6350 in September, and you would still be out of the money, because the option to sell the FTSE at 6400 when the market is at 6350 market is only worth 50 points at £10 a point, which is less than the £1009 you paid. So maybe instead of that put option at 6400 you would prefer a put option at 6900 instead....

It's much more likely that the market will fall below 6900 than fall below 6400. But unfortunately that makes the option more expensive. A put option for September FTSE at 6900 costs 209.7. So to buy enough cover to get you the same £10 of gain for every 1 point of the FTSE, will cost £2097 instead of £1009. And because of buy/sell spread, the option you paid £2097 has a cash-in value of £1977, so you can see that 10% of your option cost is going to the middleman, you'd need a 22 point drop tomorrow just to cover that and get your money back, if you wanted to exit.

Clearly if the put option level is higher, it's less likely to expire worthless. But as you're still only buying £10 of value for every 1 point of the FTSE, the index could end up at 6700 (200 pts below the put level) and you get £2000 (200pts x £10) as the cash-in value at maturity, yet you paid £2097, so you've lost nearly a hundred quid. By paying more for the option it has to beat its 6900 target by much more, for you to break even, than if you bought a cheaper option like put at 6400, or a 'worst case scenario' one like a put at 4800. Basically, insuring against something that's quite likely to happen, is expensive.

If you just think it will go down 'a bit', and buy one of those options at 6900, it can end up at 6700 with you still not in profit, while meanwhile your £70k "real world" portfolio lost £4k as the market dropped from 7100 to 6700. You lose over 5% of your real world portfolio and your hedge didn't function at all, it didn't make a net profit. You have to have a 'decent' fall to make a profit.

If you bough a put option for FTSE September 4800 at a tenner a point, it would only cost you £100 ish, so would only need to expire at ten points below the 4800 level for you to breakeven. And really if you have £2000 available to spend on options, you could afford to do twenty times as much as that, like £200 a point instead of £10 a point. Then when the FTSE actually ends up at 4000, 800 points below your 'put' level, you make £200 x 800 points which is £160,000. That would easily cover the losses on a £300k FTSE-invested portfolio, for the price of a £2k option.

So insurance can be cheap against surprising catastrophic events. But to cash out that level of profit on the 'FTSE at 4800' option, we're talking about FTSE losing 44% of its value in five months, which is pretty unlikely. If the market fell by 33% instead, still losing a third of your real-world portfolio value, the market would be at 4780, barely below your 4800 option level. You would barely be in profit on the option and nursing £100k of losses on a £300k portfolio out in the real world.

So if you're looking for insurance, make sure you are buying the right type of insurance for what you want. Option pricing can be complex. Broadly speaking: If the likelihood of the option being 'in the money' at some stage is higher, it is more expensive. So if the final maturity date is far off -it is more expensive. If the market is more volatile at the time you want to buy the option - it is more expensive. If the option is more likely to end up 'in the money' (a put option with a higher strike price or a call option with a lower strike price) - it is more expensive. If you are not an investment bank with the ability to write your own puts and calls directly in the market, and have to go through retail providers like IG and pay their 'spread' on the spread bet - it is more expensive.

However, buying 'options' by way of spread bet service provider will allow you to get tax free profits because betting winnings are not taxable, so that's nice. Conversely they do not count as tax deductible capital losses if they go wrong and expire worthless.

fabsaver

Many thanks for the comprehensive reply bowlhead :T I knew I could rely on you to answer my question. There is certainly a lot to think about there!

I've always considered financial derivatives as an ultra risky type of trading. However if used correctly it appears they can provide the tools to lower the risk of catastrophic events.

I often see 'use of financial derivatives' mentioned when reading the objectives for managed funds. It's impossible to know what exactly this means for a particular fund. Are they aiming to insure against losses or just trying to increase the returns on their fund?

It brings me back to the whole managed or tracker debate. There has been a stampede into tracker funds lately and I have personally moved some (not all) of my funds out of managed and into trackers. The lower costs are obviously great in a rising market but what happens when the market starts falling?

If a fund manager is using low cost derivatives to insure their fund against catastrophic losses then is that fund lower risk than an equivalent tracker?

ColdIron

fabsaver wrote: »

It brings me back to the whole managed or tracker debate. There has been a stampede into tracker funds lately and I have personally moved some (not all) of my funds out of managed and into trackers. The lower costs are obviously great in a rising market but what happens when the market starts falling?

You get the same lower costs and your tracker continues to track the market or index down to wherever it goes. A managed fund might be able to mitigate the fall or it might not

bowlhead99

fabsaver wrote: »

I often see 'use of financial derivatives' mentioned when reading the objectives for managed funds. It's impossible to know what exactly this means for a particular fund. Are they aiming to insure against losses or just trying to increase the returns on their fund?

Financial derivatives just mean something that is derived from the price of some other financial instrument. Quite what derivatives (and underlying financial instruments) a fund might use will depend on its strategy.

If it is an "absolute return" fund which tries to deliver a positive return even in negative or flat markets, they might be using all kinds of fancy techniques, shorting stocks and bonds, trading currencies etc, puts and call options with caps and collars and straddles etc.

If it is a simple long-only fund which wants to spend your money buying you diversified equity or bond exposure in the pursuit of income or gains, the fact that they say they can use derivatives does not mean they are going to spend your money shorting stocks or buying insurance against things falling in value instead. The strategy of the fund would be frustrated if they started blowing money on option costs and downside protection when they had not told investors it was the type of fund designed to preserve capital in a downturn. If investors want to overlay some stock market or currency hedges, the investors can do that for themselves.

However, that long-only fund might still use other derivatives in some instances. For example:

- if they want a particular share they could buy it through "contract for difference" to get a synthetic exposure instead of directly buying the appropriate number of the underlying stock.

- if they have cash on hand from some subscriptions that haven't yet been deployed - more than they need for pending distributions, but not enough to buy a decent amount of all the holdings already in their portfolio in the desired ratios - they could just dump the money into an index tracker or total return swap for a market basket. Better than it just sitting in cash with nil performance.

Maybe they want to exit a position but can't because of insufficient market liquidity, or because the share is subject to a lock-up rule for some reason due to the way they acquired it. So for now, they could short it and then all the gains or dividends earned from that point would be owed to someone else, even though they technically still owned it, but had been given the cash for it allow them to move the portfolio on and come back and deal with that holding later.

So, plenty of ways they can use derivatives in a way that doesn't mean they are "insuring losses". Insurance is just one of many ways of using a derivative. In many cases it's just slang for taking an efficient short-cut. They would want to tell you in their investment policy that they might use derivatives, so you don't get annoyed and try to sue them if you make losses after they had used something in the portfolio which was perfectly normal but hadn't been included in the catch-all comments in their prospectus.

If a fund manager is using low cost derivatives to insure their fund against catastrophic losses then is that fund lower risk than an equivalent tracker?

Perhaps.

However, there aren't really any trackers that do that though - because the costs would cause it to deviate from the return of a "proper" tracker that didn't do that and most would reject it because of the large "tracking error".

So you would be talking about an active fund, and nobody wants to pay active management fees for a fund that basically mirrors (but lags) the performance of a tracker under nearly all market conditions. So in order to get a decent sized investor base it would have to be an active fund with quite a different portfolio. And once the portfolio is quite a different portfolio to a passive tracker, the risk and volatility will likely be different anyway, and may be perceived as lower or higher risk than the tracker, regardless of the use of "catastrophe insurance".

Also, they could have semi-catastrophic losses for which the insurance doesn't pay out because the catastrophe isn't big enough, and they have lost out on performance by wasting money on insurance premiums. Or they could have proper catastrophic losses for which the insurance doesn't pay due to failure of a counterparty...

AnotherJoe

Hedge funds, which by definition do this sort of sophisticated trading (?betting?) have, over the past few years, had utterly useless returns, and this is funds being run by professors and economist nobel prize winners and the like with all sorts of super computers running fancy algorithms. So, perhaps its not as easy as it appears?

A trailing stop loss would be cheaper. Though when to re-enter if its triggered is always the question.

brendon

There is a reason that this book is free. You have no business buying puts. The only real reason you would buy a put is if you wanted to take a short-term view on the market without having to trade in and out of many positions (perhaps incurring taxes).

But you have a small portfolio, probably in tax wrappers, and can easily rebalance your portfolio to the desired level of risk. If you want to limit your downside, simply include more bonds or cash in your portfolio. You do not have to waste your money on insurance.

Malthusian

The reason I invest in the stockmarket is because I expect it to go up in the long term. I have no idea what it is going to do in one year, and buying one-year put options therefore makes no sense to me.

The fact that I have a portfolio of long equity positions suggests that on average I expect the stockmarket to go up - not every year, and I am certainly not expecting a period of positive returns to coincide with a revolution of the Earth around the Sun - but more often than not. Which means that I expect to lose money on the put option.

I could pretend to myself that it's all part of some very clever hedge fund strategy but the reality is I am doing two entirely different things, investing for the long term and gambling on short term market movements. And the fact that I am doing both indicates cognitive dissonance.

fabsaver

ColdIron wrote: »

You get the same lower costs and your tracker continues to track the market or index down to wherever it goes. A managed fund might be able to mitigate the fall or it might not

It was a rhetorical question really, but thank you for answering it

You would hope that a professional fund manager would be able to take some action to mitigate a loss. In reality who knows until the situation arises. Meanwhile I'm going to keep a balance of both managed and tracker funds.

fabsaver

bowlhead99 wrote: »

If it is a simple long-only fund which wants to spend your money buying you diversified equity or bond exposure in the pursuit of income or gains, the fact that they say they can use derivatives does not mean they are going to spend your money shorting stocks or buying insurance against things falling in value instead. The strategy of the fund would be frustrated if they started blowing money on option costs and downside protection when they had not told investors it was the type of fund designed to preserve capital in a downturn. If investors want to overlay some stock market or currency hedges, the investors can do that for themselves.

However, that long-only fund might still use other derivatives in some instances. For example:

- if they want a particular share they could buy it through "contract for difference" to get a synthetic exposure instead of directly buying the appropriate number of the underlying stock.

- if they have cash on hand from some subscriptions that haven't yet been deployed - more than they need for pending distributions, but not enough to buy a decent amount of all the holdings already in their portfolio in the desired ratios - they could just dump the money into an index tracker or total return swap for a market basket. Better than it just sitting in cash with nil performance.

Maybe they want to exit a position but can't because of insufficient market liquidity, or because the share is subject to a lock-up rule for some reason due to the way they acquired it. So for now, they could short it and then all the gains or dividends earned from that point would be owed to someone else, even though they technically still owned it, but had been given the cash for it allow them to move the portfolio on and come back and deal with that holding later.

So, plenty of ways they can use derivatives in a way that doesn't mean they are "insuring losses". Insurance is just one of many ways of using a derivative. In many cases it's just slang for taking an efficient short-cut. They would want to tell you in their investment policy that they might use derivatives, so you don't get annoyed and try to sue them if you make losses after they had used something in the portfolio which was perfectly normal but hadn't been included in the catch-all comments in their prospectus.

Thank you. The fact that fund managers have these tools available to them and don't use them for insurance purposes says something.

It's easy to find funds that are hedged against currency fluctuations but I don't recall seeing any specifically promoting stock market hedges.

Perhaps.

However, there aren't really any trackers that do that though - because the costs would cause it to deviate from the return of a "proper" tracker that didn't do that and most would reject it because of the large "tracking error".

So you would be talking about an active fund, and nobody wants to pay active management fees for a fund that basically mirrors (but lags) the performance of a tracker under nearly all market conditions. So in order to get a decent sized investor base it would have to be an active fund with quite a different portfolio. And once the portfolio is quite a different portfolio to a passive tracker, the risk and volatility will likely be different anyway, and may be perceived as lower or higher risk than the tracker, regardless of the use of "catastrophe insurance".

Also, they could have semi-catastrophic losses for which the insurance doesn't pay out because the catastrophe isn't big enough, and they have lost out on performance by wasting money on insurance premiums. Or they could have proper catastrophic losses for which the insurance doesn't pay due to failure of a counterparty...

Yes I was talking about active funds.

In your examples above it was possible to insure against a 44% fall for a reasonable cost. However even that represented about 0.67% on a £300k portfolio for only 5 months 'cover'. The cost of insuring a more likely 20-30% fall would be so high it could wipe out any positive returns.

fabsaver

AnotherJoe wrote: »

Hedge funds, which by definition do this sort of sophisticated trading (?betting?) have, over the past few years, had utterly useless returns, and this is funds being run by professors and economist nobel prize winners and the like with all sorts of super computers running fancy algorithms. So, perhaps its not as easy as it appears?

A trailing stop loss would be cheaper. Though when to re-enter if its triggered is always the question.

Very true. I've always avoided hedge funds on the basis that I don't invest in something I don't understand. It sounds like I'm not missing out.

I've never used stop losses and have just ridden out market crashes over the past 25 years. I very much doubt I'd be able to time the market well enough to make it work.