How to Insure Your Portfolio With Options
Portfolio insurance is an attempt to protect the values of a stock portfolio in the event of a large downward move in the stock market. If you use options to insure a portfolio, you can continue to make money if the stocks in the portfolio continue to increase in value, but not lose money if the stocks fall in value. Portfolio insurance using options makes the most sense if you have a fairly large portfolio holding a diverse selection of stocks.
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Instructions
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Determine which stock index most accurately reflects the composition of your stock portfolio. The NASDAQ-100 is primarily technology stocks; the Dow Jones Industrial Average is composed of large blue-chip stocks; and the S&P 500 provides broad coverage of the majority of U.S. stocks. Put options (the right to sell the underlying security for a set price) on these three indexes are usually used for option portfolio insurance purposes. Put options on indexes will increase in value as the index declines.
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Calculate how many put-option contracts will be required to equal the value of your stock portfolio. For example, with the Dow Jones Industrial Average at 10,000, a single DJX contract will provide for $10,000 worth of stock. For the NASDAQ-100, the NDX options have a value of 100 times the index, or $180,000 if this index is at 1,800. Mini-NDX options are 1/10th the value of the regular options. The S&P 500 also has regular options (SPX) at 100 times the value of the index, and mini-SPX options worth 10 times the index. With the S&P 500 at 1,100 an SPX option contract would cover $110,000 worth of stock. If your stock portfolio consisted of $500,000 of a diverse list of stocks, five SPX put-option contracts would provide adequate portfolio insurance.
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Determine an appropriate strike price for the put-option contracts. If the chosen stock market index falls below the strike price, the put options will be "in-the-money", increasing in value as the index value falls. Options with a strike price near the current value of the index are "at-the-money" and will start generating immediate profits to offset losses in the stock portfolio if the market moves downward. Options that are further "out-of-the-money" will cost less than at-the-money contracts but will provide less return if the stock market does decline.
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Option contracts have a specific expiration date. If you believe the market is going to have a near-term decline, select put options with a one- to two-month-out expiration date. If you're unsure when you think the market may decline, look at longer expiration contracts. Longer-term option contracts will be more expensive than ones with a shorter time to expiration.
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Purchase the number of put options you need to cover the current value of the portfolio.
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Monitor the value of your stock portfolio and the stock index on which the put options are based. If stock values increase significantly, the insurance protection of the options will be reduced. You may want to sell the currently held put options and buy new contracts with a higher strike price and possibly extend the expiration date.
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Tips & Warnings
Index options are cash-settled. If your contracts are in-the-money at expiration, the amount they are in-the-money will be automatically deposited into your brokerage account.
Portfolio insurance with options can also be accomplished by buying options on the comparable ETFs. ETF options don't cash-settle, so in-the-money contracts must be sold before the expiration date to avoid assignment.
Portfolio insurance using put options has cost-of-the-option premiums. If the market doesn't decline, the cost of the options will reduce the portfolio's overall return.
Portfolio insurance doesn't work if the options aren't owned when the market declines. Care must be taken to balance the amount paid for the options against the chances of the market making a significant decline.
