One of the primary reasons that financial markets exist is to shift price risk.
Hedging to protect positions comes in many forms.
The most common price protection comes in the form of insurance. Buying a put can put in a price floor for your portfolio of individual stock.
That insurance is not free, a cost not unlike protection bought for other assets like houses, cars, or even your life…
Investors often do not embrace the need to insure stock positions. The reality of your house not burning down is not viewed as a negative but paying for puts that expire worthless can be upsetting to some…
The cost of the options is the insurance premium cost with the distance to the option strike the deductible to be paid in event of a loss.
A balance between that protection cost and financial exposure make for better night’s sleep.
One way that some investors get no cost protection is through a Collar Strategy.
A collar pays for the puts by selling covered calls.
The no net cost protection is financed by selling out of the money calls. It caps profits to the limit of the strike sold but eliminates out of pocket costs.
The sacrifice of limited upside is a trade off for a position price floor.
Sell calls to pay for put protection.
There are enough things to worry about in life…adding the day to day market volatility risks doesn’t help you rest any easier…A portfolio protection TWIST will help you sleep like a baby…
Protection for your most valuable assets, life, home and auto goes without saying as a smart investment. The cost of the insurance is more than offset by the peace of mind knowing you are covered in any unfortunate incident.
Unfortunately, few hedge against the risks in the stock market leaving exposure to large swings in equity prices. A long-term time horizon has proven to be successful as markets have always rebounded so far but the mental costs can also be expensive.
PICK A PLAN
Much like other insurance the first step is to determine how much protection you need. Another step in the process is to determine the deductible.
The greater dollar amount you are willing to be responsible for lowers the cost. Decide if you want to limit losses to 5%, 10% or a more catastrophic 20%+. Stock Index puts to limit risk at varying levels can be priced and compared.
Buy puts to place absolute portfolio price floor below.
S&P 500 SPY options represent 100 shares EX. SPY At $210 value $21,000
(SPY is one tenth size of broad market S&P 500 index.)
Time is the next consideration, a method of rolling out expirations can reduce that cost as well. Time decay starts 90 days before expiration with sharper acceleration in value losses inside of one month.
To alleviate a large degree of the melting buy nine-month options and exit them when they have three months to go. An immediate roll into new nine-month option maintains protection and repeated twice a year.
If a nine-month SPY put is purchased at $10 ($1000) it is worth about $5 ($500) six months later if the market at the same price. The actual time decay and cost for the six months of protection was $500.
That six months of protection maintained unlimited upside with a cost of just over 2% of the $21,000 value.
As with any insurance the premium paid is for protection, that assurance that the asset value will be there is a small cost to pay.