Insure your Portfolio with Put Options

Just like you can get insured against losses from vehicle accident, fire, theft, etc., can you insure your portfolio against stock market crashes? While insurance companies do not offer such a cover, portfolio insurance is an investment hedging strategy that can help you avoid losses—or cut them—if the market falls. 

It involves buying stocks in the cash market and put options—rights to sell stocks at a decided strike price—in the futures and options (F&O) market. So, if there’s a rise in the stock price, you will gain from it and, if the price starts falling, you can exercise your put option to sell stocks at the strike price, thus limiting your losses. And, as is the case with other insurance policies, portfolio insurance too comes at a premium—it is the price investors pay to buy a put option. 

Monthly put options are costly 

Monthly options are the most liquid in the F&O segment. But their cost is high.  Though the premium varies based on market conditions—it goes up when market turns volatile—monthly premium is usually around 1%, which is very costly. Bear in mind, besides this premium, investors also have to bear brokerage costs. Also, if you are hedging your stocks using the Nifty put options, your portfolio should have a strong correlation with the Nifty, 

DECODING THE TERMS 

*Put option: Put option is the right to sell a security (or an index) at a predetermined price. 

Strike price: This is the price at which the transaction can be executed. 

Premium: This is the price investors have to pay for buying the put option. 

In-Money put option: The stock’s current price is less than the option’s strike price. 

Out-of-Money put option: The stock’s current price is more than the option’s strike price. 

Settlement date: This is the date on which the options are settled—the last Thursday of every month. 

Long-dated options are a better choice 

To pare down costs, experts suggest you opt for long-dated put options. To illustrate, the price differential between the 10,500 Nifty put options with settlement dates 28 Dec 2017 and 27 Dec 2018 is just Rs 187 or 1.8%. 

Long-dated options can stretch up to five years, but quotes for put options beyond one year are not readily available. Since liquidity is very low in long-dated options, the best strategy for retail investors is to go for one-year options and then roll over to the next year. Since most portfolio managers hedge their portfolio on a calendar year basis, December option is the most liquid one, so stick with it

Long-dated options insure your portfolio for a longer term and don’t come at a much higher price, compared to short-term options. 

Investors can also reduce their premiums by opting for out-of-the-money put options. Here the strike price is less than the existing stock price or index level.