Portfolio Insurance

Many people are surprised to learn that it is possible to purchase insurance on your investment portfolio. For long term, buy-and-hold investors it’s probably not worth it, since with any insurance you have to pay for that protection. The costs ultimately create a drag on the portfolio’s long term return (since over very long periods of time markets are expected to go up and so will your basic, simply-diversified portfolio if you can just sit on your hands and ride out the tough times).

Nonetheless, there may be situations where it does makes sense… and come to think of it, if holding the insurance means you are less likely to sell off your portfolio at inopportune times then it can indeed be a great investment in and of itself.

So What Is It?

Portfolio Insurance is actually provided in many different forms, but the one I’m going to focus in on is the Purchasing of Put Options.

First, we must define what a Put Option is: A Put Option is a contract which gives the option holder the right, but not the obligation, to sell an underlying security (stock, bond, ETF, etc) for a set price during the life of the contract. Okay, so what the heck does that mean… Let’s explain with an example.

Let’s suppose that you own a stock that is currently trading at $50/share. If you own it, that means you think it should probably go up, right? Well, you also know that stocks can move either up OR down in price and sometimes bad news can bring a stock’s price down in a hurry. If you wanted to protect against a decline in price you would purchase a put option on this stock. Perhaps you would purchase a put option that gives you the right to sell this stock for $48/share at any point in the next 6 months. You have to pay for this option however, and the price might be $1/share. This means that if the stock suddenly fell in price below $48/share in the next 6 months, you wouldn’t particularly care since even if the stock was trading at $40/share you could exercise your option to sell the stock for $48/share to the person you bought your put option from.

If the stock never trades below $48 and you never exercise your option during the life of the contract that’s fine – the contract just expires worthless. Whether you exercise your option or not, that price you paid for that contract ($1/share) is forever lost. And if you wanted your portfolio “insured” at all times, you would have to buy a new put option contract when the old one expires – which in this case would cost your portfolio 4% per year. That is a significant drag on your portfolio when the markets are moving up, however it’s a perfectly acceptable cost when the markets are dropping and it works in your favour, right? Well, since the markets tend to go up 2/3 of the time and down only 1/3 of the time it may not be worth using on a constant basis.

The graph below show the profit-loss of just buying our example stock for $50 (shown in the dashed grey line). You can see that the break-even point is the $50 mark of course (since you are neither up nor down at this point). If the stock’s price goes up, so does your profit. If the stock goes down in price, you could lose up to $50/share if the stock became worthless (or 100% of your investment).

The colourful line which goes from red to green shows the profit-loss profile of buying the stock and buying a put option with a $48/share strike price with a cost of $1/share. The investor is protected from ever losing more than $3/share – this is made up of the distance of the purchase price of the stock ($50/share) from the strike price of the put option ($48/share) PLUS the cost of the put option ($1/share). The cost of the put option also moves the breakeven point to the right to $51/share (purchase price of stock plus cost of the option), and it also creates a drag on the upside performance (just the cost of the option). In this case, the downside is limited while the upside is again unlimited, albeit with a slight drag.

If you are thinking about implementing portfolio insurance, there are a couple of things you can do to lessen the drag on your portfolio:

First, you can purchase a put option with a lower strike price, of say $42/share. This represents insurance that protects your investment from dropping more than 16% as opposed to 4% as would be the case with a $48/share strike price used in the above sample case. If you own an individual stock or even a broad market optionable ETF, a 4% movement (in either direction) is par for the course on a regular basis. I would rather buy a put with a strike price that you know would make you jittery if the underlying stock ever fell to those levels. You would dramatically cut the cost of the insurance (and resultant drag on the portfolio), and you wouldn’t worry about a regular correction (since you are protected), meaning you are less likely to sell at the wrong times like most people.

Second, you can pick when to implement the insurance. When the markets have just tumbled, option prices go up for puts as there is more volatility and fear. You probably don’t need the insurance after a correction just happened anyways, so I wouldn’t be buying puts right now for example. On the other hand, when your portfolio has been growing faster than the long term average you expect for your portfolio, it might be a better time to consider the puts. When markets are chugging along, there is less fear and put options may be cheap to buy.

However, irrespective of put option pricing, i.e. even if puts always cost the same, I would still recommend giving more thought to puts after your portfolio has been on an upward tear as opposed to after it has tumbled – you are more likely to need the protection reverting down to the mean and less likely to need it after a market correction has just happened.

I think I’ll stop right there since this has been a fairly lengthy post, but we have only begun to scratch the surface! I’ll write more about options and strategies in the future if you guys are interested. As a final note, I should point out that 1 option contract is for 100 shares of the underlying security so if you wanted to buy 1 put option contract for $2/share you would want to own 100 shares of the underlying stock and the cost of the option contract would be $200 + commissions (maybe $15 at a discount brokerage).

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