Options Theory: The Protective Put

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.

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%.

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