FINANCIAL TOOL
Put Option
Did you know you can buy insurance against market downside?
That’s right. It’s expensive. But in certain cases I believe it’s very much worth it.
A put option is exactly that.
It gives you the option to sell your shares at a pre-agreed price called the “strike price.”
Imagine you own a stock index called XYZ, and it’s priced at $100.
Maybe you’re bullish but you don’t want to risk any more downside than 15%. What could you do?
You could buy a put option on XYZ shares with a strike price of $85. That means even if your shares drop below $85, you can still sell the shares for at least $85.
Note that options have an expiry date. But you can buy options for a long time. You can buy them for a year or longer if you want.
Here’s the thing about options: every option covers 100 shares of a stock or ETF. So if you own 500 shares of XYZ, you would buy 5 options of XYZ to cover the full downside beyond 15%.
Options are going to vary in price depending on several factors. But to give you an idea, buying a put option for one year with a strike price set at 15% below the current price might cost you somewhere around 2-3% of the portfolio position you’re protecting.
Expensive right?
But think of it this way.
If there is a reason why you can’t afford to lose more than 15%, then it may be worth the cost.
These reasons could include needing a large chunk of the money within the next few years, for one reason or another.
Or it may be a way of keeping you from otherwise trying to jump out of markets in volatile times.
Assume XYZ has the following returns over five years: 20%, 0%, -25%, 35%, 28%.
That’s an average of about 9.23% compounded annually.
If you held a put option that cost you 3% and protected beyond a 15% drop, then your net profits would have been something like: 16%, -3%, -15%, 31%, 24%.
That’s an average of about 9.21% compounded annually.
In this example, the final results are nearly neck and neck. But here’s the important difference. If the investor needed to protect the money beyond a certain drop in the short-term, then the put option strategy was worthwhile.
Because in the midst of the bear market, the put option strategy allowed the total portfolio to retain higher value during the worst parts of the downside.
And if the investor needed to make a quick withdrawal during that time, they wouldn’t be withdrawing from such a low-valued portfolio.
There are other strategies you can perform with options, but this perhaps is the simplest. And it can be powerful for certain short- and medium-term goals!