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Using Put Options to Protect Your Portfolio

As options are a fairly sophisticated method of investing/speculating, I rarely write about them as I’m a big believer in sticking with the basics.  However, with the expectation of some sort of market correction between now and October 2010, I’ve had thoughts on ways to hedge a portfolio to reduce the potential for loss.

One way to protect a portfolio is to purchase insurance in the form of put options.  What is a put option?  If you recall our detailed series on how call options work, put options are the opposite.  Where buying a call option allows an investor the option to purchase a stock at a particular strike price, a put option allows the investor the option to sell a stock at a particular strike price.  Basically, it allows the investor to bet that the underlying asset is going to depreciate. 

An Example of Put Option Hedging

The best way is to explain this concept is with an example.  In this case, lets take a look at the Canadian stock index with the iShares ETF XIU.  If you are an ETF indexer, there is a high probability that you own XIU, but how do you use puts to protect it against depreciation in the event of a market meltdown?

If I go to my online stock brokerage console, I see that XIU currently trades at around $17.75 (May 17th, 2010).  If I go to the options quotation section of my account, I see listings for various XIU put options at specific strike prices and associated premiums.  Of course, the higher the strike price, the higher the premium and vice versa. 

In this case, say I buy a 5 x Sept 2010 put option contracts for $1 with a strike price of $18.00.  As each contract represents 100 shares, out of pocket, this means I purchased $500 (5 contracts x $1 premium) worth.  If the market does the double dip recession as many perma bears are predicting, XIU would approach the $13 mark.  What does this mean for the put option?

As I purchased $500 worth of “insurance”, and the market corrects significantly, the insurance would pay out handsomely.  In this example, lets assume that XIU is worth $13 on expiry (3rd Friday in Sept 2010).  What kind profit would I have? 

(Strike price – current stock price – premium + time value of shares) x 100 x number of contracts

As we’re selling at expiry, the time value would be $0.  Doing the calculations, it would be:

($18 – $13 – $1) x 100 x 5 = $2,000 (400% return on investment) 

In case your wondering, XIU would need to close below $17 (strike price – premium) before the Sept expiry in order to be “in the money” or profitable.  The investor can sell the option itself at any time before (or on) expiration without purchasing the underlying shares (as most do).

What is the risk?  If the markets are higher (or around the same price) by the time expiry rolls around, you’ll lose 100% of your option investment, or $500 in this case.  However, is that a bad thing?  It simply means that the underlying index is still strong, and that your insurance was not used.

Do you use options to hedge your portfolio? If not, do you use other strategies?

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 15 comments… add one }
  • Houska May 25, 2010, 11:10 am

    Thanks for the detailed explanation.

    In my opinion, the use of puts like this might be helpful for those who need a bit more stability in the short term, i.e. those for whom a loss now would put some plans in jeopardy.

    As a long term investor (in my 30s), I am not doing so for the following reason. Puts at different strike prices are market traded and hence their cost reflects average market sentiment (plus transaction expenses). In the example you give, your insurance costs about $1/share, or about 5% of market value, for 4 months protection. This reflects market sentiment and on average – if the market is right – should just break even. In other words, if I did this many times over multiple economic cycles with half my portfolio, and didn’t do it with the other half, then over the long term both halves should do about equally well.

    What this means is that a put strategy makes sense in two cases.
    a) You feel you have better insight than the investor population on average as to the level of risk in the market. I don’t feel I have that – if I did, I would be stock picking
    b) You are disproportionately sensitive to a market downturn versus the average investor (and yet you still want to stay fully invested).

    Makes me wonder – conventional wisdom is that as you get closer to needing your invested capital (e.g. retirement etc), you should lighten up on equities. I wonder under what circumstances would it make sense instead to keep the equities but load up on insurance through puts?

  • The Passive Income Earner May 25, 2010, 12:30 pm

    Great post. I know from watching BNN that many money management firms actually use puts to generate income from their investments while holding it. It’s definitely another way to generate income from your holdings provided you can handle the possibility of selling some of your holdings. Anyone done it?

  • Andrew F May 25, 2010, 12:54 pm

    Passive Income: I think you’re referring to writing covered calls, where you own the stock, and sell the option to buy that stock from you at a particular price in exchange for the premium.

    Some investors will sell in or at the money puts (covered by the cash necessary to purchase the stock if they are exercised) as a way to purchase a stock at a slight discount (3-5%) from where it is presently trading.

  • The Passive Income Earner May 25, 2010, 1:40 pm

    Thanks for the clarification. I have not ventured in the options trading land. Not sure if I ever will.

  • wciu May 25, 2010, 2:22 pm

    The problem with hedging is that they reduce the overall return for your portfolio. You are effectively paying for stability. The question is, if stability is that important to you, should you be investing in the equity market or should you look at your portfolio allocation for longer term stability?

    In general, I am against buying puts as hedges because it tends to promote people timing the market and speculation. (I think the market is probably going to go down in the next two months, so I’ll buy a put.) I just think that it start you down a path that you don’t want to get into. Also, most people only think about buying puts as insurance when the market becomes fairly volatile, which is probably the worst time to buy puts. I know, because that’s the time I start selling puts as limit orders for companies that I like with price near or above fair value.

    For me, I would only buy puts on equities with extreme likelihood of major capital lost that I cannot recover from. But then, why would I have such equities in my portfolio in the first place?

  • Phil May 25, 2010, 5:51 pm

    wciu: “The problem with hedging is that they reduce the overall return for your portfolio. You are effectively paying for stability.”

    Enough said; I rest my case.

  • 1stmilliondollar.net May 26, 2010, 9:19 am

    Sorry, I am a little bit confused here. So, what do you do with 500 shares of XIU? It was originally traded at $17.75. So, when the market is down to $13; you’ll be losing money on these shares, i.e.:

    (13 – 17.75) x 500 = -2375

    Even if we get a profit of $2000 from the put options; we’ll still be losing money from the stock, $2375.

    Am I missing something here?

  • FT FrugalTrader May 26, 2010, 10:47 am

    1stmilliondollar, in that case, buying put options would hedge your position. Assuming your numbers are correct, using put options would result in a loss of $375 instead of $2375.

  • wciu May 26, 2010, 1:14 pm

    In response to Phil:

    “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” – Warren Buffett

    Keep in mind, people selling you those puts that makes you feel comfy are probably the creme de la creme of the investment community, and they are not in the market to lose money.

  • Tommy O'Dell May 26, 2010, 8:10 pm

    Just wondering if anyone has an understanding of how this fits in with Nassim Nicholas Taleb’s The Black Swan? From what I understand, his thesis is that the market significantly under-prices the risk of big events (like Sept 11th, Black Monday, etc). Does he advocate going ultra long with really “long shot” put options? Is that accurate?

  • wciu May 27, 2010, 1:29 pm

    Tommy: It’s been a while since I’ve read that book, but here’s my take on that.

    Going ultra long by buying put options is an over simplification, since you need to take the price and payout into account. It is a good strategy when puts are grossly mis-priced, i.e. betting pennies will get you a expected payout of a dollar. In normal circumstances, options prices do not give you that kind of odds, but in a full fledge bull market, or in stocks that are over hyped you can find those opportunities.

    Conversely, when everything seems really bleak, there can be a black swan that gets you a huge return. In a sense,Graham’s Net-Net is an example of this. You invest in a basket of stocks that looks bad but financially sound, one of which might become a 10-bagger and more than cover the cost of all other “mistakes”.

  • Phil May 27, 2010, 9:29 pm

    In response to wciu:

    Remember that no investment strategy is “costless” once opportunity costs are accounted for. To me, people using options are under the impression that they can fundamentally eliminate downside risk without decreasing upside return… and obviously it’s not guaranteed to outperform a simple buy-and-hold strategy. What do you reckon?

  • wciu May 28, 2010, 1:40 am

    Phil:

    In order to eliminate downside risk without reducing upside return with puts, I would need to be able to accurately predict that the market will go down and by how much. Even though I would like to think I am that smart, I am just not. Even if I was, I would just buy and sell options and not bother with equity at all.

    Also, with all option contracts, you will always have a counter party. Your counter party will charge you a premium for taking on the downside risk for you, especially when everyone believes that the market will go down. So you have to ask yourself, have they mis-priced the downside risk? When most people wants to buy puts as insurance, the sell side almost always has the benefit.

    Lastly, you really have to ask yourself, are you hedging to enhance your return, or are you hedging for mental comfort? I suspect most people who buy puts as hedge will think they are doing the former, but the real reason is the latter. If you feel your mental comfort is worth the price of the hedge, then by all means use that strategy. For me, I would rather make sure that holdings in my portfolio are of high enough quality that I won’t panic on days that DOW drop by 1000 points for no reason. :)

  • Andy May 28, 2010, 4:28 pm

    OK- some of the comments regarding put options are scaring me…

    Options can be fire. If you do not fully understand what you are dealing with you will almost certainly loose money. Do not use options to try to profit off the daily ups and downs of the market. Options are specifically priced (using a mathematical formula called the Black Scholes equation) to ensure that the ‘expected’ (ie. the based on recent price history) ups and downs of the market will not lead to a profit. Options only result in profit when a significant unexpected event occurs (like the recent 10% correction).

  • Derek June 2, 2010, 3:19 pm

    Options are fun!

    Just use with caution. I think the Montreal exchange has a ‘nice’ site to learn more and is well laid out for finding Canadian options with prices and outstanding options.

    I have personally several derivative ideas and like what Nassim Taleb says. However its always easier to read than implement.

    Personally right now i either buy in the money calls on less volatile large caps with a dividend (Loblaws comes to mind) or sell puts to get into a company i want to own at a cheaper price.

    NOTE; if you sell puts make sure you want to own the company if it goes down (use Buffet buying Burlington Northern as an example of this)! Also i can’t for the life of me understand why someone would sell naked calls?

    Limited upside with unlimited downside?? Hmm. Taleb also covers this in his book.

    I wrote a few short articles about options here: http://canadianoptions.blogspot.com/
    (look at the earlier articles in 2007) but i’ve mentioned alot of it above.

    The site is a sort of journal of my trading and has evolved more into value, but i still like to dabble with options when spreads company’s permit.

    Not only is option trading more expensive, but the spreads lately have been massive on options i’ve looked at like PNSN for example.

    Derek

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