When equity markets rise and market sentiment becomes euphoria, investors should consider purchasing insurance to protect their portfolio. Although market environments constantly change, fear and greed always seem to be the driving forces behind market movements. In this article we will touch on three reasons to purchase a protective puts.
Put Options Basics
A put option is the right, but not the obligation, to sell a security on a specific date on or before a certain time. The date when the option matures is referred to as the maturity date while the price that the put option buyer can sell the security is called the strike price. Options are traded as contracts where each option contract equals 100 shares of an underlying stock. A protective put is the purchase of a put to protect against the erosion in value of securities held.
The majority of the options traded on regulated exchanges are American style options which mean that the buyer of the option can exercise the option at any point prior to or on the expiration date. The act of exercising an option is exchanging the option for the underlying security. For example, if an option buyer purchased one S&P 500 index April put at $100 dollars, they could exchange their option for a short position of 100 shares of S&P 500 index at the price of $100 dollars at any time prior to expiration.
Reasons to Purchase a Protective Put
1) Premiums are Low – A protective puts protects your portfolio from an adverse market change. The price of a put is generated by market participants based on the current price, current interest rates, as well as implied volatility. Implied volatility is the markets estimate of how much a security will move over a specific period of time on an annualized basis.
For example, if market participants believe that Apple Inc. will move 30% during the next 365 days, the implied volatility of the security is considered 30%. High implied volatility equates to higher premiums for options prices. When fear is pervasive implied volatility is generally high, as investors experience trepidation that riskier assets will tumble. When complacency rules market sentiment, implied volatility is generally low. As equity prices rise to new heights, implied volatility declines driving option prices lower making protective puts a good option to protect a portfolio.
2) The protective puts can insure that a portfolio is protected from an adverse move and acts similar to insurance. The only downside to a protective put is the premium that is paid to the option seller for the right to sell a security or basket of securities. If complacency continues to occur and markets grind higher, the investor will continue to benefit from their portfolio gaining in value.
The payoff on a protective put strategy (as shown in the diagram below) shows how the gains in a stock price is offset by losses associated with the protective put. The diagram also reflects a specific level where the portfolio remains unchanged if the price of the stock moves lower. In this case, the investor’s portfolio is protected at levels below the strike price of the put, and the only loss is the premium the investor pays for the right to own the protective put.
3) With interest rates at historical lows, the alternatives to stocks such as bonds and cash generate little value to an investor. A protective put allows an investor to remain diversified, while protecting their portfolio from an adverse market move. Protective puts avoid issues related to dividends which can occur in short call positions, and assist in the process of maximizing portfolio gains.
A protective put is a defensive strategy that can be used by investors to protect their portfolios from adverse market movements. The protection of the security begins at the strike price of the put, and continues to protect the investor as the security moves lower. The benefit of using a protective put is that the investor understands that the maximum loss that can occur by using this type of insurance is the premium paid to purchase the put option. The best time to purchase a protective put is during market complacency when market sentiment is positive.
This was a guest post written by Marcus Holland of FinancialTrading.com.