Put Options In A Volatile Market
As volatility creeps back into the stock market, it is a good time to revisit protection strategies. Moving to cash is not really a viable solution for many in this low interest rate environment with inflation eroding your nest egg.
Just like we buy insurance for our auto, our house, our health, our life, etc., you can use a long put strategy or implement a put protection strategy to protect your investment portfolio.
Buying a put option is a strategy used to protect a portfolio against adverse or extreme market movements. Through the use of stock and index put options, investors concerned about declining markets can protect their portfolio without the need to exit their position, sell the stock or liquidate their holdings.
Advantages of Buying Puts as a Hedge
If you have held stock for a long period of time buying put protection can reduce your long exposure or even go short with your portfolio without selling stock which eliminates the capital gains tax that you would have incurred with the sale of the stock.
Many times, the whole idea of going through your portfolio, picking and choosing which stock to sell and then executing the orders in the market can be a time consuming as well as daunting task. Purchasing an index put option can instantly reduce your long exposure across individual stocks held in your portfolio without the need to sell your stocks one by one.
This helps Eliminate transaction costs. Purchasing an index put means there is only one transaction involved, without having to close and pay brokerage for each individual holding. Each put contract generally covers 100 units of the underlying stock and each index option covers 10 times the value of the index.
Why Buy Protection for Your Portfolio?
For most, a stock investment portfolio is one of the biggest assets and a key component for retirement. If you insure other things in your life, why wouldn’t you also protect your stock portfolio and retirement account? Buying puts and the strategy of using protection for your stock portfolio could be one of the smartest things you do for your future retirement.
For example, if the market drops 50%, it will take a 100% return for your investments to break back to even and get you back to where you originally were. Losses steal both time and money so you have to be aware of the negative consequences of a correction, crash or bear market. If you were able to hedge your portfolio when the market dropped you would have saved yourself subsequent losses with the purchased put option(s).
However, there is another side to buying protection that you have to understand. As volatility rises in markets, protection will get exponentially more expensive as sellers demand more premium to take on the that risk. The VIX is a indicator of market volatility. As the VIX rises, options become more expensive.
What are the Risks in Buying Put Insurance?
The only risk you have is if the put option you purchased as insurance expires worthless. This is the preferred situation as you would want your portfolio to rise and for your gains to exceed the cost of the option contract in the long term.