In my previous article, I talked about different methods of protecting your stock portfolio. As I explained there, the most commonly used technique is a stop-loss order. With this technique, you identify a price and tell your broker to sell your stock if it drops below your target. I also explained how to use put options and covered call options as another way of protecting your stock portfolio. My preferred method of managing the downside is the use of equity and index options.
A put option gives the holder the right to sell an asset for a specific price by a specific date. A call option gives the holder the right to buy an asset for a specific price by a specific date. For example, if you buy one November 80 put option on IBM (currently trading around $82), you have the right to sell 100 shares of IBM at $80 by November 17. Your put option will increase in value if IBM declines. Prices of put options, move in the opposite direction of the asset. If you purchase a November 85 call options on IBM, you have the right to buy the stock at 85 until November 17. Your call option moves in the same direction as the stock price, and will increase in value if IBM moves up.
I use equity options to manage the risk of stocks in my portfolios. I’ve noticed that even with an excellent stock-picking system, there are always unknown factors that could impact the stock prices. These include geopolitical events, accounting scandals, and unpleasant earnings surprises. There is a need for a continuous process to protect an investment portfolio. Common risk management techniques such as stop-loss orders, or percentage loss of equity won’t give you a continuous protection. If I purchase 500 shares of IBM for a client’s account, as on a needed basis, I purchase 5 of the IBM put option contracts to protect the downside. I use fundamental and technical analysis to determine the amount of protection (e.g., the dollar value which I’m willing to lose on this investment), the expiration date (e.g., the length of time that I like to have this protection in place), and the option strategy (e.g. either a put option or a covered call). Buying a put option is similar to purchasing insurance for your property; You pay a premium in order to protect your investments. Selling covered calls will give you limited protection but will generate some income.
In addition to being an excellent risk/profit management system, a well-designed option Strategy will also reduce the volatility of your portfolio. This reduced volatility is due to protective put and covered call options. In both cases, they avoid large drops or speculative increases in a typical portfolio, and keep the portfolio fluctuations at a reasonable rate. I keep track of our positions without put/call options, and compare its risk and return versus our regular portfolios. On a continuous basis both the volatility and risk-adjusted returns are higher for risk-managed accounts (e.g., portfolios with protective put and covered call options).
You could use either an equity option (e.g. IBM put options) or an index option (e.g. S&P; 500 put option) to protect your portfolio. An index put option gives you downside protection during the market declines. For example, if you purchase a put option on S&P; 500 index, and the market declines by 10 percent, the value of the option will rise between 2 to 9 percent. This, to some extent, will offset the drop in your portfolio’s value. If you decided to use index options, you need to select the most appropriate index for your portfolio. The index you select must closely duplicate your portfolio. For example, if your holdings are mostly high-tech stocks, you will be better off using QQQQ or NDX index instead of the SPX index. Other considerations are the cost of purchasing index options versus the cost of purchasing several equity options, and ease and speed of execution. In many cases, selecting equity options and protecting your investments one by one is safer and more appropriate than using index options. Equity option strategy is more difficult to design and will cost more to implement. However, it’s not unusual for an individual stock to drop significantly (e.g. an unpleasant earning announcement) in a rising market. Having an index put option will not protect your portfolio in this situation.