Buying insurance to protect your portfolio

You may not have known it, but options are in essence, exchange-traded insurance policies, even though they are often used for speculative purposes. You can buy an option to protect the value of your portfolio, for instance, by setting a “floor” that will support your assets in case the market price collapses. Let's take one example:

We're going back in time, to August 2000. Mr. Y, a calm but risk-averse investor who prefers stable yields, had bought 1,000 shares of XYZ in December 1998 at $20 per share. In August 2000, the stock is trading at $124 a share and Mr. Y is getting nervous.

Mr. Y hears two voices in the market. The first voice belongs to stock analysts, who are saying XYZ will be monstrously successful because it is the industry leader in Internet infrastructure components. The other voice is Mr. Y's sceptical conscience, telling him the Internet bubble burst four months earlier, in April 2000. If XYZ's high price is based on expectations of continued exponential growth in Internet demand, the stock may be overvalued if Internet growth slows down instead.

As a longtime buy-and-hold investor who likes to own boring but high quality stocks, Mr. Y is a little flustered to see the huge yield in his portfolio in just a year-and-a-half. While he likes the fact that he is now quite a bit richer, he fears this could be short-lived (everything that goes up must come down). He contemplates selling his shares but believes the stock still has good growth potential . Instead of selling his shares, he decides to protect them by buying 10 XYZ December 100 put options. This guarantees him the right to sell his shares at $100 should the stock tumble below this price. He thereby sets a $100 protection "floor" for his shares. This floor is costing him $2 per share, or $2,000, to protect a $124,000 position.

Scenario 1: The stock stays above $100

If the price of XYZ stays above $100, Mr. Y will be happy because his money will still be in his account, and the market will not have taken it away. He paid $2 per share to buy an insurance policy he ultimately didn't need; much like a car owner who buys insurance but doesn't get into an accident.

Scenario 2: The stock falls below $100

If the stock's price drops, Mr. Y has an insurance policy guaranteeing him the right to sell his shares at $100. He can enjoy his gains and will be happy to have avoided the losses that decimated the accounts of many other XYZ shareholders.

Two frequent questions

There are usually two questions that come up about this strategy. First, since the stock was trading at $124, why did Mr. Y set a floor at only $100? Wouldn't he have done better to set the floor at a higher price? The answer is simple: better protection costs more. For example, if Mr. Y had bought 10 XYZ December 120 put options, thereby setting the floor at $120, they would have cost him $18 a share, for a total outlay of $18,000. In his opinion, this was too expensive. He preferred reducing his protection by $20 a share to reduce the cost of his premium.

The second frequently asked question is this: why didn't Mr. Y simply put in a stop order to sell his shares at $100? (A stop order lets you tell your broker that you want to sell your shares as soon as a trade takes place at or below a trigger price.) In the case of XYZ, the closing price on October 24, 2000, was $102.50. The next day shares opened at $75. If Mr. Y had sent a stop order with a trigger price of $100, he would have ended up selling his shares at $75. These gaps in stock trading, caused by the announcement of bad news or by trading halts, can cause real harm. A stop order cannot save you from gaps, but buying a put will protect you.