What is Portfolio Insurance? How to Completely Hedge Your Stock Portfolio of Risk With The Use of Put Options (While Only Marginally Capping Your Upside.)
The following blog post will look at a tactic in portfolio management known as portfolio insurance, which describes the use of put options, to hedge and de-risk a portfolio. If done correctly, even large portfolios, in the dollar amount attuned to millions or billions of dollars, can actually be completely hedged against the risk. The downside of this, is that on the upside, your gains on the portfolio are also hedged.
An example of this, is say that I have a $1 million portfolio, comprised holy of the S&P 500. What I can do, is by put options, which are leveraged at 100 times the value of the S&P 500, so essentially, depending on what the premiums are at this current time., I’d be able to hedge a $1 million portfolio, completely, for nine months, for somewhere around $10-$50,000. This would likely be around $25,000, to fully hedge against any downside risk, on a $1 million portfolio. Even a slight downturn of 10%, in a portfolio like this, and have astronomical gains, in the case that the market has a slight downturn with in the next nine months. I’ll put options expire and the third Friday of every month, and typically have nine month expiration periods.
Hedging a Portfolio
The same can be done when buying insurance against a short portfolio. Say I have a $1 million short position, on the S&P 500, or on the Vicks, or on a European bond, or on a high-yield corporate bond, or even on a single blue-chip stocks like Walmart. What I can do, is hold my normal sure position against Walmart, or the S&P 500, and from there, purchase index call options against the S&P 500. This way even if the stock skyrockets, my short positions are hedged, and I do not have unlimited losses, as I otherwise would when holding onto a short position. Overall, portfolio Insurance can be an extremely useful use of options or leverage, and other warren Buffett is typically called them powerful tools that should be used carefully, I think that they are useful, in nearly every single large scale portfolio.
Why Hedging Your Downside Risk is Both Good and Bad, The Details on the Question of What is Portfolio Insurance?
With all the good that comes with purchasing portfolio insurance, there sure is a heck of a lot of bad, and this comes by way of premiums, ie. the fees that the broker charges you on the put options that you’re purchasing in order to de-risk your portfolio (you didn’t think you were getting a free lunch here did you?) Which often times can be as much as ten to fifteen percent of the actual buying price of the stock, in the case that the put options are exercised! Watch those put options expire worthless and you won’t be sleeping good for at least a couple of weeks, that’s for freaking certain.
The other downside to these, is that they really only work if you have a lot of money, or at least moderately a lot of money. Ie. if you are a college student with $5,000 that you are trying to invest, gamble or speculate with (whatever floats your boat, I’m personally more of a Modern Portfolio Theory, index fund investing type of guy), then you can’t even really afford one blog of put options, as they can be upwards of $8,000 in premiums! With that however, you can receive as much as $800,000 or $1,000,000.00 of portfolio insurance and downside coverage. So if you have a $100,000.00 portfolio, or a $1,000,000.00 portfolio, than put options are absolutely a powerful part of one’s portfolio. Start with far less than that however, and…well…..with premiums at as much as $8,000 a pop, you can imagine how that can really start to snowball in a negative direction.
As a quick little addition to this blog post nearly a year after it was first written, I want to comment on this and say the for the most part, trading in options unless you are an institution is typically a losers came for pigs. The reason is that because it is so hard to time the market, which is exactly what options allow you to do, speculate on what markets will do in the near to moderately near future, but they allow you to do it in a way with significantly more leverage and in a way where the possibility for loss is astronomical. For 99.99% of investors, even if you are experienced or even if you have $10,000,000.00 in net worth and you are gambling no more than you can afford to lose, like $10,000, I would say that it is prudent for you to be cautious with regards to options trading, and that probably more cautious investment vehicles are much more prudent.
Final Thoughts on Answering What Portfolio Insurance Actually Is
In short, portfolio insurance is basically buying put options, ie. an insurance policy against your downside RISK, in the same way you would buy an insurance policy against your car, your home, or your health. It is about RISK MANAGEMENT, and the TOTAL COST OF RISK, and about monitoring that risk, both for yourself and the insurance company. It is the same with options, put options, loans, or anything else in finance or in life. If you have a very high payoff on your options, there is more RISK to the lender, and he needs to be compensated for taking that potential risk. How is he compensated? He makes more money in premiums.
The same goes on the other end of the options trade, if it is a very low risk trade, sure, you’ll pay less in premiums, but you’ll also have much less of an upside, if, in the case of put options, something happens such as the market turning sour during a pandemic outbreak, or a dot com bubble crash. Hopefully that gives you a basic understanding of options, put options, and portfolio insurance. If you enjoyed this blog post, be sure to subscribe to our blog for additional details and information, and to comment down below with your thoughts and opinions on the article, and we’ll get back to you within one business day with a response.
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