Manage Risk with Puts

Portfolio Insurance

••• Puts Can Provide Peace of Mind (at a Cost). Pixabay

Question from a reader

I own a stock portfolio worth $500,000 and fear a market correction. I want to protect the value of my portfolio from a 20% decline in the value of the S&P 500 Index. How many SPX put options must I purchase to satisfy my needs? 

Let's work this out with an example. SPX is currently trading near 2050 and a 20% correction would take it down to 1640.

Your question contains a little ambiguity, so let's clarify first.

Most people think of "protection" as a method that limits losses to some acceptable amount. Think of an insurance policy with a deductible. Is that what you have in mind? Or, do you mean that you want to lose ZERO if the market declines by 20%?

In either case, you must buy enough puts to offset a specified loss from your half-million dollar portfolio. For this discussion, let's assume that you want to recover all, or almost all of the loss, on a market downturn. If you need less protection, all you have to do is spend less money by buying fewer puts.

With SPX near 2050, let's say that you buy one ATM put (strike 2050). You can choose the expiration date because you want to buy an option that does not expire while you still fear that market decline. If you have no specific date in mind, then I suggest buying options that expire at least three to six months in the future. As you already know, it is necessary to buy these puts before the market heads lower.

If the market declines by ~20% (to 1640), then your put would be in the money by 410 points and would be worth $41,000. Therefore, you should buy one of these puts for each $41,000 worth of protection that you want -- if and when the market declines to somewhere near 1640. In this example, to recover the whole $100,000 loss (excluding the not insignificant cost of buying the puts), you need 2.5 SPX puts struck at 2050.

Because you cannot buy part of an option, you can buy two SPX 2040 puts plus 5 SPY 205 puts.  Note: 5 SPY puts (with a strike price of 1/10 that of the SPX put) are almost the same as one-half of an SPX put.

Important Points

  • Keep in mind that even when your fear comes true, the market is unlikely to decline by exactly 20%. That is not a problem because you can customize just how much protection you want to own for any given decline in the market.
  • There is no need to buy costly at-the-money puts. You can choose out-of-the-money options that cost far less. For example, instead of owning the equivalent of 2 ½ puts struck at 2050, you could buy puts with a strike price of 1900 (or any of a large variety of other strike prices). If the market declines to 1640, each of these puts would be in the money by 260 points and provide $26,000 worth of protection. It would only require that you own four of these puts to gain that $100,000 worth of downside protection (at SPX = 1640).
  • However, please understand that these cheaper options are cheaper for a big reason: They may provide no help at all if and when the market undergoes a smaller decline. And statistically speaking, that smaller decline is far more likely than a larger decline. For example, if the market dives by 10% -- down to 1840, then these the SPY 1900 puts would be worth $6,000 each, or $24,000 total. That is far less than the $100,000 worth of protection than you seek.
  • The bottom line is that when you buy out-of-the-money options, you can incur a double loss: Your portfolio loses value on a decline as the puts expire worthless (because the market does not decline by enough). So, if you want protection against the big, 20% decline, you can get that by owning cheaper OTM options. But understand that a smaller market decline affords little, or no protection at all.

If you are willing to lose $25,000 on your feared debacle, then you would need enough puts to earn 'only' $75,000 if SPX were to fall to 1640.

BTW, the above calculations assume that all options are held to expiration. The situation becomes more complex when we examine the value of the options prior to expiration. (Because the remaining time value in the options can add quite a bit of value to your options if the implied volatility increases as the market falls).