Using put options to insure portfolio against losses?

fabsaver

brendon wrote: »

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.

Your comments appear quite condescending. I certainly wasn't reading this free book in the hope of finding a strategy to follow. I already have my own, but it is always interesting to read about alternative strategies and new ideas. I came across a new idea I hadn't heard of before and didn't know much about - so I asked the experts on here.

Having discovered more about the use of put options I have concluded that it certainly isn't as straightforward and cheap as the book would have you believe.

That is quite an assumption to make about the size of my portfolio

fabsaver

Malthusian wrote: »

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.

I wouldn't be in the stock market either if I didn't expect it to go up in the long term.

Stock market crashes can be triggered by unexpected unforeseen events. In other areas of our lives we have insurance against such events, so the idea in principle is worth considering.

However it is an ongoing cost and would mean purchasing another put option every year, or more if shorter terms were bought. If there was a stock market crash say only once in 15 years, the total cost of all those put options over the previous 15 years would be the true cost of having that insurance. Furthermore to properly hedge it would mean buying separate options for every index in a well diversified portfolio. That would get very complicated.

Anyone reading that book and consequently putting all their money into S&P 500 is going to need some insurance :eek:

Malthusian

fabsaver wrote: »

Stock market crashes can be triggered by unexpected unforeseen events.

Stockmarket crashes are expected and forseeable. We know when we invest that there will be crashes and that at times our investments will fall dramatically. Only the timing of them is unknown.

In other areas of our lives we have insurance against such events, so the idea in principle is worth considering.

But before buying a put option I have to decide what the expiry date is going to be. There's no sense in buying a one-year put option unless I expect to spend the money in a year's time. If I know I won't spend it in a year's time - for example, because it's my retirement fund - it's a waste of money. There is no event to insure against.

Whereas if I do expect to spend it in a year's time, insuring completely against stockmarket loss would be so expensive that I'll have virtually nothing left to invest. Cash would be a better option.

Anyone reading that book and consequently putting all their money into S&P 500 is going to need some insurance :eek:

No they don't. In October 1987 the S&P 500 was at a record high when it crashed on Black Monday; those who invested at the peak were back in profit in 1989. In 2007 the S&P was at a record high when it crashed due to the credit crunch; those who invested at the peak were back in profit in 2011. In 2000 there was a real stinker of a crash which took the S&P ten years to recover from - illustrating why you should diversify geographically, not why you should buy put options.

If you are unlucky enough to invest your money in the stockmarket when it is at its peak (they usually are) and just before a crash, you will still make superior returns to cash over the long term providing you follow the three golden rules (a. don't panic b. diversify c. don't invest borrowed money). This has been the case for every previous crash and there is no reason to think the next one will be different.

Specific geographic sectors are however occasionally subject to "lost decades" which is why there are better ways than investing all your money in the S&P 500.

jamesd

A search for "put write strategy etf" will get you a list of some tracker ETFs which use puts to track an index created for that purpose. Zacks describes some. They should be expected to do worse in a rising market than a plain tracker and better in a falling one.

Some equity income funds sell options to sacrifice capital gains by generating income from the selling.

A fund needs to say whether it will use derivatives and might decide it's not worth the hassle and costs involved, which might include more oversight or reporting. It'll also need to pay employees with the requisite ability to do it.

Pincher

Buying Put options? Insurance costs.

On the other hand, writing covered options works your asset harder.

Assuming you have 100 shares of ABC, so you write a call option, and somebody buys it for £10. If the share price doesn't move much by expiry, you keep the £10, and the shares.

If the share price goes up, and the buyer exercises the right to buy, then you have to sell at the contract price. So, you get the proceeds of the sale, and the £10. Not a disaster.

If the share price is stable, then you keep getting £10, on top of the dividends.

You do need a trading platform that lets you use shares as collateral against open option positions.



There is an interesting way of having a position without putting money down. I had some shares in a company, and I noticed a news announcement. An investment fund had £400million worth, but needed the money to do something else, so they bought the call options (probably OTC, to save time) around the price, and sold £400million worth. As it turns out, the share price sank, so I lost out, but they were pretty smug, I'll bet. All they lost was the cost of the call options, which will expire eventually.

fabsaver

Malthusian wrote: »

Stockmarket crashes are expected and forseeable. We know when we invest that there will be crashes and that at times our investments will fall dramatically. Only the timing of them is unknown.

It is the events which trigger stockmarket crashes that are unexpected and unforseeable. Yes we know that a stockmarket crash could happen anytime, but we don't know what the triggers will be.

But before buying a put option I have to decide what the expiry date is going to be. There's no sense in buying a one-year put option unless I expect to spend the money in a year's time. If I know I won't spend it in a year's time - for example, because it's my retirement fund - it's a waste of money. There is no event to insure against.

Whereas if I do expect to spend it in a year's time, insuring completely against stockmarket loss would be so expensive that I'll have virtually nothing left to invest. Cash would be a better option.

If you have plenty of time to wait for recovery then sure you can argue that no insurance is needed. However if you do have the insurance then your portfolio is bounced back up as soon as the put option is exercised. Then you would have a much larger portfolio to benefit from the recovery in the years following a crash.

Taking bowlhead's example earlier:

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.

You have a £300k portfolio and that 44% (or more) crash does happen for whatever reason. Your portfolio has fallen in value to £168k and you would have had to wait several years for it to recover. However you also have £160,000 (from exercising the put option) to invest in your portfolio. Total portfolio now more than what you had initially. You are now in a great position to benefit from any strong growth in the recovery period following the crash. Say the following year the stockmarket bounces back by 20%. Without the put option you now have just over £200k. With the put option you have almost £400k.

The expiry date would be up to you but the suggestion in the book is that it is treated like a regular insurance policy. That is you would just buy a new one every year on an ongoing basis. If no catastrophic crash has happened (or it wasn't large enough to trigger the option) then the cost of that 'insurance' is lost.

Obviously this insurance costs and I am in no way saying this is the right strategy for anyone. Costs eat into investment returns, and the chances of having the right level of insurance in place when a crash happens is doubtful. Maybe it would be a better strategy to buy lottery tickets rather than put options

No they don't. In October 1987 the S&P 500 was at a record high when it crashed on Black Monday; those who invested at the peak were back in profit in 1989. In 2007 the S&P was at a record high when it crashed due to the credit crunch; those who invested at the peak were back in profit in 2011. In 2000 there was a real stinker of a crash which took the S&P ten years to recover from - illustrating why you should diversify geographically, not why you should buy put options.

If you are unlucky enough to invest your money in the stockmarket when it is at its peak (they usually are) and just before a crash, you will still make superior returns to cash over the long term providing you follow the three golden rules (a. don't panic b. diversify c. don't invest borrowed money). This has been the case for every previous crash and there is no reason to think the next one will be different.

Specific geographic sectors are however occasionally subject to "lost decades" which is why there are better ways than investing all your money in the S&P 500.

I think you may have taken my comment the wrong way Investing entirely in one geographical region at an all time market high is scary :eek: Diversification will always be one of the best methods of 'insurance' That doesn't mean that other methods shouldn't be considered.

EdGasket

If you buy this 'insurance' then you won't benefit so much from stockmarket gain and will lose money on the puts even in a static market. You'd also have to decide when to activate the put if the market goes down; a tricky business.

Ref. post by Brendon "If you want to limit your downside, simply include more bonds or cash in your portfolio."

I don't consider bonds low risk right now with inflation and interest rates set to rise; cash would be better but still susceptible to inflation loss.