Buying Puts Strategy for Portfolio Protection
Hedge your stock portfolio and manage risk using long puts as a protective investment strategy.
In modern markets volatility is becoming the norm rather than the exception. Going to cash may be unattractive in a low interest rate environment with inflation eroding your nest egg. Similar to buying insurance for your car and house, you can use a buying puts strategy or put protection investment strategy to protect your stock portfolio.
Portfolio insurance using puts
Buying a put option is a strategy used to protect a portfolio against adverse market movements. Through the use of stock and index put options, investors concerned about declining markets can protect their portfolio without the need to liquidate their holdings. This has three advantages.
- No CGT event. By buying put protection, you can reduce your long exposure or even go short with your portfolio without triggering a CGT event associated with selling stock. A lot of our clients have held stock for many years and a CGT event would be highly undesirable.
- Faster execution. Purchasing an index put can quickly reduce your long exposure across individual stocks held in the portfolio without the need to sell your stocks one by one.
- Lower 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. For example, 1 index put option will cover $50,000 (5,000 x 10) if the ASX200 index is currently at 5,000 points.
Buying Puts Strategy - Why buy protection for your portfolio?
For many, a stock portfolio is their biggest asset and assurance for retirement. If you insure your car, house and income, why wouldn't you also protect your stock portfolio? This buying puts strategy of using buying 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 get back to what it was. In fact, the Australian market struggled to return to its 2008 highs of 6,600 index points more than 8 years after the GFC. If you were able to hedge your portfolio when the market dropped 20% you would have saved yourself 30% in subsequent losses.
However, there is a downside to buying protection. As volatility rises in more uncertain markets, protection will get exponentially more expensive as sellers demand more premium to take on the risk. However, with strategy advice from a PhillipCapital adviser, we can help you pick the opportune moment to buy put option for protection or even go short and position for a fall in the market.
Buying put protection example
Let's say for example you own 1,000 shares in stock XYZ. You bought the stock for $50 and XYZ is now trading at $80; you feel the stock will fall in the short term and would like to protect yourself against this fall, but you don't want to sell the stock.
In January, you buy 10 XYZ February put contracts at a strike price of $80 for $1 per contract. You will pay in cash $1,000 ($1 x 10 x 100) plus brokerage and you are protected until expiry in February.
If XYZ falls to $70 at expiry, the value of your put contract will be worth $9,000 ([$80 - $70 - $1]* 100 * 10). The value of the underlying stock would have depreciated by $10,000. Your net loss is $1,000, which is the premium paid for the contract. You can exercise your put option and sell your stock for $80 to the seller of the contract or if you would like to hold the stock, you can sell to close the option on market before expiry to lock in the option profit.
If XYZ stays above $80, you will lose the $1,000 in premium, which is the cost of the put option insurance. You can also sell this ahead of time before expiry if you feel the market will move back up.
Alternatively you can protect a portfolio with index puts. Each index put covers 10 times the value of the index price and is a quick and effective way to hedge a large portfolio.
What are the risks in buying put insurance?
The only risk you have is if the insurance contract expires worthless. In fact, this is the preferred situation as you would want your stocks to rise and for your capital gains to exceed the cost of the contract in the long term.
Bought Puts Guide
If you want to take advantage of this investment strategy for hedging and protect your investments, contact one of our friendly, experienced and fully accredited options advisors.