OG grabs the reins for his usual Thursday rant!
This week, the US equity markets quietly reached a “four-year high,” prompting many (including me) to question the validity of this recent rally. The market is up nearly 26% over the past 12 months. During this same time we’ve had:
– the dreaded “downgrade” of the US debt,
– the Eurocrisis, Spain, Italy, Ireland, and of course Greek near-defaults
yet most people won’t feel much richer if you ask them “how’s the market doing?”.
As a practicing advisor, whenever I hear “lowest ever” or “best ever” or “all-time” anything, I automatically consider the inverse. As CNBC, Fox News, CNN and Bloomberg keep us glued to their networks with fear and greed, I’m left wondering…
So I’ve begun thinking about protection strategies.
Today, lets talk about about a powerful tool: the Put Option.
Wait! Don’t run away! It’s actually a good way to shelter your investments AND it isn’t nearly as difficult as you might imagine. While many option strategies are pure speculation, this one is designed for the conservative investor…the one who wants to insure everything.
Let’s say the S&P 500 closed at 1420. We can go out and buy an S&P 500 index fund that mimics the index, (ticker – SPY). If you look up SPY on any finance site you’ll see today’s closing price and you’ll notice it trades at 1/10th of the actual index’s price. Since we assumed the S&P closed at 1420, the SPY would close at 142.
Now let’s further assume that you’re okay with day-to-day volatility of a few percent here and there, but you want to prevent the catastrophic loss of 20% or more over a few trading days – the so called “Black Swan” event. What we want to do then is to protect our current account against future loss, or said another way, we want “the ability (or option!) to sell at today’s prices sometime in the future.”
Wouldn’t it be nice to say “I want a do-over” if the market collapses and our funds slide?
The tool that accomplishes this is called a put option and it allows us to do exactly that. We have to pay for this option, so let’s explore what that would cost. It might not be worth the price.
If we pull up January 13 Put Options for $130, we’ll see that we can buy those for $3. January 13 Put Option means that we can sell the options for $130 anytime we want between now and the third Friday in January. This represents about a 9.5% decline from today’s prices and the $3 price per contract means that we’ll lose another 2% to cover the investment.
Here’s how I figure all this out
1) I determine the amount at risk. There are many risks, but in this case we’re talking about stock market risk. If your portfolio is $100,000 and you have 50% in stocks, your amount at risk is $50,000.
2) Next, I decide how much downside I’m comfortable accepting. As we discussed, a 10% decline is tolerable, but a 20% loss is catastrophic. I decide to insure everything below a 10% loss.
(side note – why don’t I just insure it for the current price? The cost to do this is nearly always huge. It’s like insuring your house….having a deductible of 10% is much cheaper than insuring every instance.)
3) Next, I’ll find prices. Using today’s numbers, it would cost me $3 per share to cover everything below a 10% loss.
4) Fourth, I do the math, which isn’t difficult. Don’t let it scare you. My amount at risk is $50,000 divided by $142 (todays SPY price) is 352 hypothetical shares of SPY. Although options are priced per share, they’re purchased per 100 shares. I need to buy four contracts to insure all my amount at risk.
4 (contracts) x $3 x 100 = $1,200 or roughly 2.4%.
5) Now I make my decision, weighing each outcome. Lets list them:
Outcome #1 – the market stays flat or increases through January 2013. If this happens, I’ll forfeit the entire $1,200 paid for the option contracts, but would’ve had the piece of mind. Basically, an automatic 2.4% loss for insurance that I didn’t use.
Outcome #2 – The market declines, but less than 10%. In this scenario, because of my “deductible” amount, I also lose the entire amount invested in the option contracts. Insurance that I didn’t use.
Outcome #3 – The market declines greater than 10%. In this scenario, my total loss is limited to just 10%. If the market goes down 20% over the next several months, I cash in my option contracts to recoup some of those losses at anytime I want through January 2013.
6) Finally, I decide whether to pull the trigger. If so, let’s try to find an “up” day to do the trade to lower your cost a little. If not, I have to be comfortable with my decision and move on.
So now it’s your turn. What outcome would you choose? Would you buy the insurance? What do you do when you start thinking about “protecting” some gains?
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