Tag Archives | portfolio insurance

Introducing Options to the Masses: Is it Possible?

As the markets head higher, I watch in amazement.  The S&P 500 Index is marching steadily towards 1200, the DJIA has passed 11,000 and all is right with the world. And that's one reason why I am not a market prognosticator.  This rise is completely unexpected by me. 

I note that companies are making money through higher productivity, and assume they are in no hurry to add employees when they can function efficiently with so few.  However, I wonder who is going to be buying their products when so many are unemployed, and so many others have become much more conservative in their spending habits.

I shrug my shoulders and accept the fact that I cannot predict market direction.  However, I'm wondering how individual investors – those who are not optimistically bullish – are handling this market.  I know those who are fully invested are happy campers.  But are they worried?

My belief is that this is an opportune time to consider using options as a tool for reducing the risk of investing.  I would never tell any investor that hedging is necessary.  My objective is to be certain investors understand that it's possible to hedge their holdings with options, show then how to do it, and allow them to make the final decision. 


Something for nothing

I've spoken with friends who are long, and love being long.  Two have investment accounts that return 7.5 and 12% respectively.  These are not capital gains.  These are dividends and interest payments.  Not wanting to tell someone else what to do, especially when they are making money and are happy, I did ask:  Aren't you surprised to be able to earn such high returns when banks and Treasury Bonds return so little?  Aren't you concerned that these high returns are accompanied by higher than normal risk?  Don't you ask yourselves: Who would pay 12% interest when most people would be thrilled to earn half that amount in interest?

Neither friend is concerned.  One trusts her broker (not her advisor, but her broker, who is nothing more than a salesman) to take good care of her, and the other is overwhelmingly diversified, with far too many ETFs in his portfolio.  Neiher sees a problem with earning such high returns.  They see no risk – other than market risk.

 

Who needs options

To me these are the investors who should consider some from of portfolio insurance using options.  It should be standard fare as intelligent risk management.  Whether it's the purchase of OTM put options, buying collars on specific holdings, or selling a portion of the portfolio and holding more cash, it's prudent to pay attention to risk and not to pretend that markets will rise forever.  And if they do rise forever, earning less money by owning insurance is not the worst result in the world.

Investors who own home insurance, car insurance, life insurance, and insurance on other costly possessions never consider insuring their investment portfolios.  I cannot understand why this is true – other than the fact that the brokerage industry makes no attempt to alert their clients to the availability of such insurance.

I'm not suggesting that owning insurance is mandatory, but I do state that ignoring the problem and not thinking about what can be done to protect one's holdings, is a big mistake. 

That's one reason why I believe options education is a good idea for the vast majority of people who have nest eggs worth protecting.  They may decide options are not what's needed, and I would never argue with that decision.  However, remaining ignorant about how options work and not bothering to learn that they are risk-reducing investment tools, makes no sense to me.

One big problem is that those who do seek information, often find it in the worst possible places and pay exhorbitant prices to learn something about options.  Instead of heading over to one of the option exchanges, the OIC,  their broker, or a trustworthy source, investors succumb to temptations offered in TV infomercials, advertisements for weekend seminars or introductory option classes that cost as much as $10,000. 

That's far to much to spend.  An options education requires an understanding of the subject and cannot be crammed into the head of a novice over a short time span.  One must be very familiar with a topic before being bombarded with information that requires time to digest.  Graduate students can receive such detailed information in seminars, but it's inappropriate for freshman courses.

To me that's a shame that too few brokers and financial advisors suggest portfolio protection.  Investors are once again being set up for getting hurt- the next time the bear returns to dominate the market.  And that may be soon, or not for for years. 

The tragedy is that it's all so preventable, and at a reasonable cost.  I believe options should be used as hedging tools by far more individual investors, but reaching that audience has been a near impossibility

813

 


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For Protection: Sell calls or Buy puts?

Options for Rookies New Home Page



Mark,

I
know this could be a rookie comment but it hit me today that I could buy
short-term portfolio "insurance" in the form of selling a deep in the money call
for the upcoming month. Something with a high Delta that will hedge a big
move down.

I thought about buying a Put as I read most investors seem to
favor, but I would rather reduce my basis with the Call premium than
raise my basis with the Put.

It will take some monitoring to limit the
loss in the Call if the market moves back up but it seems like a good
alternative to buying a Put. (I would have to monitor the loss with the Put as
well.)

Thanks

Larry

***

Good question.  I must make assumptions due to ambiguity.

1) When you speak of selling a Call or buying a Put, the strike prices are crucial.  I assume that are using options with the same strike
price and expiration date.

2) Yes, when trading options, you can sell a deep in the money (ITM) call option to get short 80 to 100 deltas.  Yes, this provides decent downside protection.  Its effectiveness depends on position size.

  • If you own 1,000 shares of stock, one call will not help much
  • If you own 200 shares, it cuts downside risk considerable, but hurts the upside
  • If you own only 100 shares, then you have very little profit potential on a rally

This strategy is not traditional 'insurance.'  It's more of a hedge, or risk-reducing play.  So if that's the plan – selling some delta because you have too much downside risk, then this is okay.  But it would be easier to unload a portion of your position and forget insurance.

3) It's true that buying puts is expensive, and is often a huge deterrent to investors who want to own insurance.  Thus, it's a real trade-off.  Pay for the puts and own real insurance – insurance that guarantees a minimum value for your position – or look for ways to save money and own less effective protection.

If you choose to buy that far OTM put (corresponding to the strike price of the call you are considering selling), the put will not be costly.  However, it takes a significant decline before insurance kicks in.  It's equivalent to owning an insurance policy with a large deductible.

I understand the difficulty in making a decision.  We all want to reduce, rather than increase, the cost basis of our holdings.  I tend to own insurance when it is inexpensive (IV is far too high for that right now).  The way I provide minor insurance for my portfolio is to reduce position size.  It's one way to get some protection without having to pay for those costly puts.

One more idea:  Instead of owning 'complete' protection, you can buy put spreads.  These provide limited protection at a much lower cost.

775


RookiesCover "
This is a great book for starters in options. It challenges you and at
the same time you want to continue to the next chapter.A must reading
for entering the option field." DW

"Good beginners book. A concise and conservative approach to trading
options. I’ve bought several copies and given to friends and family to
allow them to become aware of another way of investing in the stock
market."  EE

"Overall, I’m very happy to have read the book, and would strongly recommend people new to options do the same." RD

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Portfolio Insurance

Mark,

You mentioned couple of times that you usually hold insurance against
black swan events. I would be interested to know what kind of insurance you carry – straight puts, spreads, expiration time etc. What
percentage of your portfolio per month do you spend on this insurance?

I
understand that there is no one right answer for this question, but I
would like you to share your view since I find myself agreeing with more
than 90% of your general trading philosophy.

Thanks a lot for your great blog!

Kim

***

Thanks Kim

I don't always hold insurance, and don't have any right now.  The truth is that it is very expensive when IV is elevated.  I manage risk by keeping position sizes a bit smaller and covering OTM spreads when they get to 15 or 20 cents.  This latter move may not seem to be much in the way of risk management, but:

  • When iron condor trading works well, it's like an income miracle.  There is no point in taking extra risk 
  • When this method doesn't work well and the markets are too violent, there is no point in taking extra risk
  • Thus, covering the far OTM, cheap call and put spreads makes sense to me

I own insurance more to protect my position than to profit in a black swan event.

My preferred insurance for protecting an iron condor portfolio involves owning extra options.  I prefer to own protection in the same month as the position being protected, but buying options that expire earlier do a much more effective job of providing protection.  They cost less and that means you can own strikes that are closer to being ATM.  The negative part of that play is that insurance expires before your position. [This idea is covered in detail in The Rookie's Guide to Options]

I have no problem with that because I like to exit my income spreads one month prior to expiration.  However, if you are like most traders and hold longer, it's not pleasant to lose your insurance, ad it will have to be replaced.

a) I want them to be less far OTM than the short options in my main position.  If short the 800/810 call spread, I prefer to own a small quantity of 780 or 790 calls.  Obviously these can get to be very expensive, so a big part of owning them is deciding when to buy.  Buy early when reasonably far OTM and they are cheaper.  Wait until they are needed, and they are more costly.  Of course, by waiting, you may never need to buy them, saving the cost. 

b) Black swan protection is good – if you are willing to spend the money.  I usually am not.  OTM puts are just very expensive, even when far OTM.  However, if you cannot afford the potential loss, it's worth every penny to spend a little money on real insurance.  Almost any puts are good for that – but be realistic when deciding how far OTM to go when buying puts.

c) When IV is low and options are cheap, I was willing to spend 20% of the premium collected on insurance.  Now, when IV is high, one gets very little protection for that cash.  I just don't buy protection when IV is as high as it is.

d) My preferred strategy for owning those extra long options is the kite spread.  That's a name I coined for a trade that looks like this (you can do the same thing on the call side):

Buy One Put

Sell three (or four) put spreads.
 
Strike of short is three (four) strikes below put bought

Pay a cash debit (these are not cheap)

Example:

Buy 2 INDX 700 puts
Sell 6 INDX (same month) 670/680 P spreads

or

Sell 8 INDX 660/670 P spreads

I like these positions because loss is limited to the debit paid for the position.  If you buy a put kite, the worst possible result is seeing all options expire worthless.  If the market declines, this position has value. 

The worst case occurs when expiration arrives INDX settles at the wing (the highest strike put in the kite).  At that point, the loss is limited to the cash paid for the position. 

The best case scenario is a gigantic move (down in this case).  Your credit spreads or iron condors may go to maximum value, but the naked long extras can earn far more than enough to compensate for all those losses.

e) Other trade ideas work, but with limited protection.  Buying call spreads and/or put spreads (less far OTM than your position being protected) costs far less and affords far less protection than buying naked options or kites.  But they do offer a decent chance to earn profits, depending on settlement price.

Kim, once you decide how much you can afford to spend, there are reasonable alternatives. 



An apology.  What a bomb.  I received zero entries for the crossword puzzle contest
I was trying to do something different, but will stick with what I do
best, and that's providing options education. If anyone cares, the
puzzle answer is below.

Puzzle_#1_answers 

767

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