As you know, you can buy car insurance, home insurance, medical insurance and life insurance. Guess what – you can also buy your own stock insurance. If you are like me, when the stock market starts falling, you probably thought you only had 3 options:
Option 1 – keep your fingers crossed and watch the numbers closely;
Option 2 – turn your back on the whole thing, refuse to look at the daily reports and hope like heck it will turn around soon.
Neither of the above options will help your situation. Market crashes occur occasionally. Market recessions occur more often. If you have been unfortunate enough to have been the victim of any of these occurrences and have waited years for the market to recover, the Option 3 below offers you a good alternative.
Option 3 – insure your own portfolio with an index put option.
The most popular Index Put Option is a SPY which closely resembles the S&P500. You will have to hang in with me here because some work will be required by you. You will have to create your own toolbox of information. In your toolbox you will need the following:
- an idea of the composition of your holdings, e.g., mostly S&P500 stocks or Dow stocks
- your own personal trading account with some money in it as, in order to execute your plan, you need to practice with your trading account by buying the smallest value puts available to see, for real, how they work
- a calculator
- the information you need is the current total value of your portfolio. Just like with your home, you need to know the value of your property. Once you have established the value of your holdings you can implement your insurance coverage.
- buy the book “Trading Options For Dummies“
To Execute Your Plan
To insure your portfolio with index puts, you need to first select an index with a high correlation to your portfolio. For instance, if your portfolio consists of mainly technology stocks, the Nasdaq Composite Index might be a good fit and if the portfolio is made up of mainly blue chip companies, then the Dow Jones Industrial Index could be used. If your holdings most closely follow the S&P500 you could use the S&P500 Index Options.
After determining the index to use, calculate how many contracts you need to buy to fully protect your portfolio using the following formula.
Number of Index Puts Required = Value of Holding to be insured divided by the value of 100 shares of the underlying stock or index,as one put contract covers 100 shares of underlying equity.) Don’t be concerned about the terminology here. All is explained when you go on to your trading account.
8/26/16 Market price of SPY is 217.29 asked.
A put contract for 100 shares would protect a market value of 217.29 x 100=$21,729 worth of stock in your portfolio.
A put 215 would absolutely protect the value of 100 shares of SPY no matter how low the market price went, as each dollar loss in stock would be offset by a dollar gain in put value once SPY goes below 215.
This insurance will be pricey, more economical would be to protect against losses greater than, say, 17%, with a put 180 which would offset losses if SPY goes below 180.
Puts are available for different durations such as until DEC 2016 or until DEC 2017. On the maturity date all options expire, with value if they exceeded the strike price or worthless if they did not.
DEC 2016 put 180 costs $105 per contract, DEC 2016 put 215 costs $636.
These prices can vary every business day. Commission costs are extra, e.g., Ameritrade charges $10 per trade plus 75 cents per contract, not a big deal.
DEC 2017 put 180 costs $733 per contract, DEC 2017 put 215 costs $1,726 per contract.
I would favor the longer term contract and renew it 12 months forward when DEC 2017 expires. This Put 180 protection is costing about 2.5% per year, which is why not everyone does it. In other words about $25 per year for each $1000 worth of protection.
I would recommend that you ask your financial advisor if this would be right for you. We are private investors and not industry professionals and have nothing to gain from anyone else’s financial dealings or decisions.