Last update: August 2021
Spectators who view the options market as an arena rampant with speculation are only half right. While there are undoubtedly many who dabble with derivatives in search of a quick buck, the lion’s share of participants use them as risk-reducers.
That’s right. The options realm is an insurance marketplace where stock owners can acquire protection against loss in their beloved equities. Rather than suffering the ravages of a bear market stark naked, risking untold percentages of their burgeoning portfolios, wise investors buy put options. ‘Tis a tactic no different than a homeowner living next to the Mississippi river buying flood insurance.
A put option is a contract that gives you the right to sell your stock at a set price. It comes with a deductible and a premium due at the time of purchase. Fortunately, it’s not a one size fits all type of contract. You can modify the deductible amount to make the cost cheaper or more expensive. Additionally, there are numerous expiration dates allowing you flexibility in how many months of protection you purchase.
The final variable impacting just how much the powers that be will charge you for this insurance is implied volatility. Think of it as the level of risk. To continue the flood insurance analogy, if the chance of flooding is high, you’re going to be charged out the nose. But if the prospect of flooding is low, then the cost will be minimal.
These days the perceived risk in the marketplace is virtually nil. The stock market just finished its least volatile year on record and investors have been celebrating an uninterrupted march of all-time highs for days on end. As a result, insurance prices are dirt cheap.
Allow me to provide a case study to illustrate.
Protective Put Case Study
Suppose you’re looking to park some $27,000 of your assets in the stock market. Rather than playing the stock picking game, you elect to buy a broadly diversified basket of the best companies on the planet using the S&P 500 ETF, SPY. With the fund trading at $273.42, you could buy 100 shares for $27,342. On a side note, if you’re using a margin account the capital requirement would actually only be half of that. Like any stock position, your potential reward is unlimited and your potential risk is 100% of your investment. The risk graph of your stock position is shown below:
Now, suppose we tapped into the power of options for some protection. To reduce the cost, we’ll buy a put with a larger deductible. And, to provide ample time for coverage we’re going to buy one year of time. The Jan 2018 $245 put option which sits 10% out-of-the-money should do the trick. Its cost is $6.55 per share, or $655 total.
Pro Tip: Buying a one-year, 10% OTM strike put is a good rule of thumb to use when seeking long-term insurance on an investment.
Here’s the way I like to think of it. The $655 is a mere 2.4% of your total investment’s value. Spending such a small percentage to acquire massive downside protection seems like a no-brainer. The reasoning for the low cost goes back to the extremely low implied volatility levels pervasive in the stock market these days. Were we in a higher volatility environment the annual cost of protection would likely double or triple (or more) to 5% to 7.5% of your total investment.
The put grants you the right to sell SPY at $245. And since you bought it at $273.42, that means your downside is capped at $28.42 plus the insurance cost, or $34.97. All told, a $34.97 loss on a $273.42 investment is only 12.8%. Check out the risk graph of the protective put position below, noting how the downside risk is capped at expiration once SPY falls below $245.
So what do you think? Is it worth paying 2.4% of your total investment’s value to reduce your max downside from 100% ($27,342) to 12.8% ($3,497) for the next year?
Admittedly, you now must make $655 on SPY over the next year just to break even. But, surely it’s not asking too much for the world’s premier benchmark, one in the midst of an epic bull market, to lift a scant 2.4% over the next twelve months is it? Heck, even if it doesn’t rise SPY still pays a dividend of 2%.
Tackle Trading Resources on Portfolio Protection
Continue learning about this powerful options strategy: Portfolio Protection. From free articles to Premium System and Trading Playbook, Tackle Trading has all the resources you need to MASTER this strategy like a PRO.
Portfolio Protection For Beginners [Free Articles]
Everyone invests. Everyone has money. Currency is a form of investment since the gold standard was removed from the currency system.
You’re a goose chaser. Admit it. It’s the gold you seek. And that’s okay. You’re in good company. Most of us round these parts have been searching for the big bird for ages. Some have even tagged one.
Come lear a Trick for Financing Portfolio Protection.
What is hedging? Come learn the basics in this 3-part series.
In part one of our new series on hedging, we defined precisely what the concept means. Today we’re turning to the why.
With a sound foundation on the what and why of hedging, we’re now ready to dissect the devil. Namely, when do I place my hedge?
The way that you go about hedging varies depending on what your strategy is. Come learn how to hedge a naughty naked put.
Today I want to talk a bit about the impact VIX spikes have on the cost of portfolio protection.
It’s nailing the management of Protective Puts that separates the men from the boys. Allow me to offer up a few ideas.
The bears are roaming. And while their sudden emergence likely spelled losses for traders far and wide, the pain doesn’t have to persist. I look at this as a “fool me once, shame on you; fool me twice, shame on me” situation.
Contrarians in a bear market seek signs of capitulation. Specifically, evidence that bulls are throwing in the towel and abandoning their once beloved positions.
Herein we explore the perks of lengthening your time horizon and embracing Long-term Investing.
Bear Market Survival Guide [Premium System]
Any investor can survive stock market crashes by using The Bear Market Survival Guide because it includes Wall Street’s best-kept secrets for portfolio protection.
Tackle Trading Playbook [FREE for PRO Members]
PRO Members now have unfettered access to the Tackle Coaches’ personal playbook containing thirty-one powerful trading strategies categorized according to the Options Greeks. Bullish, bearish, or neutral market conditions, this Playbook will help you dial up the right call more often and with greater confidence.
Financial freedom is a journey
Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.