While options are not magical devices that can create cheap stocks out of thin air, they can be used to tailor an investment portfolio's risk and return profile, and this ability can be a great benefit in a fully valued market like today's.
There are three simple option strategies that can help investors in a fully valued market:
- Protecting a portfolio from a market fall.
- Generating income by selling upside potential.
- Using the income strategy to subsidize the protection strategy.
The next three blog postings will look at each of these choices in turn.
First, let's look at how best to protect a portfolio from a market fall by buying put options.
Protecting a Portfolio by Buying Put Options
Most people know that buying put options is the financial analog to buying home insurance. But knowing this doesn't help when it comes to figuring out the nitty-gritty details of how to most efficiently buy this financial insurance.
For instance, let's say you've got a diversified portfolio of 20 stocks with a value of $100,000. Should you buy puts on each of those stocks? Should you buy enough puts on each stock to insure the full portfolio value? If and when the market does fall, what should you do with the insurance?
The first thing to realize is that buying puts is a very expensive proposition. For example, let's say I have a position of 200 shares in Cisco Systems CSCO. Cisco closed on Friday at $24.51 and I want to insure myself from the stock falling below $24 / share for about the next six months (at which time, I might decide to buy another insurance policy). Today, I could buy one put contract (one contract is equivalent to 100 shares), good through April of next year, for $1.70 / share. To insure my entire 200 share position, then, I would need to spend (200 * $1.70 =) $340. This works out to paying insurance premium of 7% of the position's value for just a little over six months worth of protection (or around 12% per year). So, assuming that all of the other 19 stocks in my portfolio cost roughly the same to insure as Cisco, I will be spending $12,000 per year to fully hedge my portfolio! That is a pretty high bar to hurdle.
Even if I decide to protect my position against the stock falling below some lower point (let's say $22), but I'll still have to pay $0.90 a share, and in addition to that, will have to pay a "deductible" of ($24.51 - 22.00 =) $2.51 per share--over 10% of the value of the shares.
Don't despair, there are things you can do to use put options more effectively in a portfolio. I have these three rules of thumb:
- Buy puts on an index (e.g., SPDR ETF SPY)
- Buy puts for a purpose
- Don't try to protect your entire position
Options on an index (both puts and calls) are always cheaper than puts on an individual stock, so to protect a diversified portfolio, you should always look to index options first. For instance, buying puts on SPY expiring next March and with roughly the same "deductible" as the Cisco puts mentioned above cost, on an annualized basis, just more than 5% of face value. Five percent of face value is still a lot for insurance--$5,000 per year in insurance costs is high--but it is a lot better than 12%!
Purposeful Puts
There is something psychologically satisfying to see a green arrow on your brokerage screen when the market is down heavily. No matter how bad things get for the Dow, one can always feel a little bit better by focusing on the gains from an index put contract. Psychologically soothing is not the most important reason to buy a put option. Ideally, we should be ready to use some of the proceeds from selling that put option to invest in something that will generate more wealth for us in the future and leave us better off long-term.
Most investors have a list of stocks they'd like to buy more of and an idea of what price they'd like to buy them. For me, I'd like to buy 180 shares of Oracle ORCL if it were to drop to around $28 per share. This transaction would cost me $5,040 and I believe net me a gain of around 30% over the long run. So, in this case, why don't I buy puts such that, if the market drops enough to bring Oracle down to my $28 buy price, I have a spare $5,000 to spend on buying those shares? This is exactly what I mean buy "purposeful puts."
From Friday's close, Oracle would have to drop around 20% to get down to $28. So, perhaps I will buy put options on the index that protect from a drop of greater than 10%--at Friday's close, that would imply buying put options struck at $152. These put options closed at $2.68 per share. If the market does drop 20% (i.e., SPY falls from $170 to around $135), at minimum, my puts will be worth ($152 - $135 =) $17 per share or $1,700 per contract. I say "at minimum" because if the market drops quickly, people will get scared and the demand for puts will increase and as it does, their value will be something more than the minimum.
Let's say I buy 3 put contracts on SPY struck at $2.68. This would cost me ($2.68 * 3 * 100 =) $804. If SPY does fall 20%, the minimum value of my puts will be ($17 * 3 * 100 =) $5,100--enough to allow me to buy the Oracle shares I want. Considering that the value of my puts will probably be much greater that the minimum, I might be able to buy more Oracle or some shares in another stock I might want to buy.
If I look at my expense for this strategy in terms of the value of my portfolio, it has dropped down to an annualized rate of only 1.5%--a much lower hurdle to cross than 5% or 12%.
However, while this strategy is cheap, has it really protected my portfolio? In a conventional sense, no. Perfect protection would be having enough cash to completely compensate one for the 20% drop in portfolio value suffered in the market drop. However, too often, investors who think about passively protecting their portfolio as they might their house are car, end up sitting on unrealized gains from their puts rather than realizing these gains and putting the cash profits to work to generate greater returns in the future. In this case, the puts may indeed provide some psychological benefit, but in terms of economic benefit, it is usually just about a wash.
If I have confidence that the market will recover from its 20% drop in within a time horizon that matters to me, I should also have the confidence to invest in my best investment idea when the market does drop. In this sense, purposeful puts whose profits are realized and plowed into a good investment does much more good than passive puts whose value is never realized.
This point leads naturally into the next point.
Don't Protect Everything
Seeing red marks on one's brokerage screen is never a pleasant experience. However, for an individual investor, real investment risk is not a risk of day-to-day fluctuations in the unrealized value of one's portfolio. Rather, real investment risk is not generating enough wealth over one's investing time horizon to meet one's financial goals. Whether your goal is to provide for a comfortable life in retirement, pass along a comfortable estate to your descendants, or build a new wing onto the local hospital, risk comes down to not being financially able to do what you want in the time frame you want.
If your investing time horizon is so short that a 20% loss in value of your portfolio would create significant hardship in terms of your financial goals, I maintain that it would be better to think of how to better allocate your assets--away from equities and other risky assets and towards government bonds--than to think about how to protect your gains using put options.
As we have seen in the preface, attempting to protect one's entire portfolio will incur a very high cost. The compound annual growth of the equity market since the end of the 1920s has been on the order of 10%. For large capitalization firms, you can expect to pay on the order of 12%-15% for a year's worth of protection. So buying protection on all of your holdings would end up generating something like a 300 basis point per year average loss. This is not good protection.
There may be times when protection on an individual name makes some sense. For instance, let's say you bought a stock on January 2 for $20 a share, and in October, it is trading for $50. Realizing profit on this investment in October will generate a higher tax bill because short-term capital gains are taxed at the same rate as one's normal income whereas long-term capital gains are taxed at 15%. If you are in the 35% tax bracket, this is the difference in paying $10.50 per share of tax by selling right now or $4.50 per share if you can wait another two months to sell. In this situation, it does make a lot of sense to buy option protection as long as you're paying less than the amount you will save in taxes.
Put Protection Summary
In my experience, most people use puts in a way similar to a security blanket. I hope that after reading this article, you will not make this mistake. In the end, security blankets are passive instruments that may make one feel better, but do not actually make one better off.
A good protection strategy starts with an intelligent assessment of risks: asking the question “Am I taking on too much risk by owning [this / this many / this kind of) stock(s)?” If you are confident that you can manage the risk of a temporary and unrealized drop in value of your portfolio, then ask the question “Is it a good time to gain exposure to a particular stock's downside potential and / or to that of the overall market?”
Given that your answer to this second question is also the affirmative, it is good to consider the characteristics of a good protection strategy:
Looking for index options when the market seems fully or overvalued, making a plan of what stock to buy if the market does indeed fall, then realizing put gains and investing in a wealth-generating asset when the time comes—this is the mark of a dynamic, intelligent put protection strategy.
In the next article, we’ll talk about another way of using options in a fully-valued market—generating income from selling away non-existent upside potential.
A good protection strategy starts with an intelligent assessment of risks: asking the question “Am I taking on too much risk by owning [this / this many / this kind of) stock(s)?” If you are confident that you can manage the risk of a temporary and unrealized drop in value of your portfolio, then ask the question “Is it a good time to gain exposure to a particular stock's downside potential and / or to that of the overall market?”
Given that your answer to this second question is also the affirmative, it is good to consider the characteristics of a good protection strategy:
- It should be a proactive investment based on a rational view, just like an investment in a share of stock is.
- It should create as low of a drag on one’s portfolio as possible.
- It should provide you with the opportunity to increase your wealth over time.
Looking for index options when the market seems fully or overvalued, making a plan of what stock to buy if the market does indeed fall, then realizing put gains and investing in a wealth-generating asset when the time comes—this is the mark of a dynamic, intelligent put protection strategy.
In the next article, we’ll talk about another way of using options in a fully-valued market—generating income from selling away non-existent upside potential.
