the arrangement that our bank asks us to make before taking on a mortgage. Insurance is a precaution and a gesture towards security.
So how is it that we do not carry an insurance policy on the hard-earned money we have invested in stocks, bonds and alternatives?
Equities, and particularly US stocks, are up nearly 100% since the $68.92 low touched by the SPY S&P 500 ETF (shown in grey) on February 23, 2009. Over the same period, US Treasury bonds (shown in orange) are up 65% as the global low- and negative-rate environment continues to prompt demand.
Moreover, TLT has outperformed the US benchmark by more than 50% over the last 10 years!
The coupling of bonds and equities is extraordinary; it's something that really should not happen. With this, we are in uncharted territory. What did Christopher Columbus, Lewis and Clark, and many other explorers rely on when they went on to explore the unknown? They had experience and they relied on their senses. For average investors, it's hard enough to process all the information in the marketplace let alone make a prudent decision.
Here are three simple steps you can take:
- Diversify across asset classes: equities, bonds, cash, alternatives (commodities, options, real estate) and so on.
- Have a plan in place: when markets are bullish we seldom think about exits. Set up your investment goals and stick to your plan during times of market volatility.
- Learn to use options: options can be used in variety of ways. Unlike conventional assets such as stocks and bonds that give you a linear exposure to the market, with options you can place time and volatility on your side. Below are three straightforward strategies that you should consider using...
Strategy No. 1: the protective put
Also referred to as a "married put", the strategy consists of a long stock position in combination with a long put. It is a classic hedge strategy.
There are number of way to step into an options strategy and this one is no exception. There are two basic questions to ask yourself here at all times... "how much time I want to be covered for?" and "what is the value I want to be covered for?"
The answers will determine the terms of your insurance.
Source: WeeklyOptionsLab Webinar No. 6
You can buy the protection for that stock at the time of entry or at any time you feel uncertain about your stock(s). For the above example, the investor buys insurance at the time of purchase of the underlying stock. An investment of $4,200 is protected with a premium of $155 ($1.55 x 100 shares) for 60 days!
Crunch the numbers and you have a guaranteed exit at $42 for about a 3.5% fee and you can enjoy all the upside in the stock.
Caught in the rain?
While a protective put does provide insurance for a stock or portfolio, it comes at a cost. The cost is determined by the market forces of supply and demand. When volatility – the price risk –in the market increases, investors will look for insurance, and just like the price of umbrellas on a rainy day, the premium in protective puts will be up.
Strategy No. 2: The enhancer "covered call"
Last week we described this strategy in detail with this trade idea.
Here's the rundown: What it boils down to is your degree of intimacy with the stock you own. Whether you are married to a winner or a loser, separation can be hard. A wise friend once said "don't fall in love with stocks; Instead love your wife and children."
Here's when you should consider the covered call:
- You are moderately bullish on the stock you own (no extremes here).
- You're OK with departing at a predetermined price.
- When setting a ceiling (or sell price) on your stock price
Source: Saxo Bank
Selling a covered call against a stock you own is a simple and effective way to enhance the return of a stock position. It's important to note that this strategy does not increase the risk in your stock (red-dotted line); in fact, by receiving premium – $0.39 in the above example – the investor is able to reduce their cost basis in that position down to $28.42.
So you have improved your cost basis and hence slightly limited the maximum possible loss in a stock!
Consistent long-term performance
Earlier we mentioned that options could be use as variations, and the covered call is no exception. If an investor believed that a stock could rise 2-3% or more in the next 30 days, they could sell a call options reflecting that expectation. The further out-of-the-money, the less premium that investor will collect... but the more upside on the underlying stock.
Below is a graph of the Chicago Board Options Exchange S&P 500 2% OTM Buy/Write Index (BXY), which systematically employs a 2% out-of-the-money call on the S&P 500:
Strategy No. 3: happy when it's up, calm when it's down (the collar)
As with other option strategies, the collar can be structured in variety of ways all depending on how much exposure or protection one wants to have. In this respect, the strategy truly is a collar in the same sense as the one around your neck. Depending on the occasion, you can button up that shirt or let it loose!
The collar is composed of three elements: long stock, short call, and long put. And while the protective put insures that the airbag will deploy in case of a collision, the covered call will finance that insurance for no money out of pocket, or in the below case for a credit.
Suppose you own shares of Facebook that you recently purchased at $127. If you purchased in the past with a lower cost basis, perhaps you have more at stake here as you have accumulated profits but only on paper. Profits can easily slip away if we don't protect them.
Long 100 shares of Facebook at $127 (net investment of $12,700)
Short 1 Facebook 130 Call at $4 => money coming into your account
Long 1 Facebook 120 Put at $2 => money leaving your account
The net effect of selling a covered call and buying a protective put produces a credit (money coming in) of $2 ($4 minus $2). The $2 for every share you own of Facebook reduces your cost basis from $127 to $125.
This is also the point at which you don't make money or lose money (breakeven). So you might be happy to make $5/share if shares of Facebook reach $130 at expiration and/or you could be calm if market turns for the worse and goes down in flames.
Your loss is limited to $5 per share. All at no cost.
Create your own charts with SaxoTraderGO click here to learn more
Source: Saxo Bank
Investors can use collars to insure both single positions and whole portfolios. Suppose a portfolio worth $500,000, for instance, mostly consists of US blue chip stocks (investors in Europe might want to use the EuroStoxx50 index in a similar fashion)...
Using the CBOE SPX (S&P 500), investors could hedge their blue chip US portfolio by purchasing a protective put on the index. At the index's current level of 2,160, a November 2,100 put that is roughly 3% below the current levels of the S&P 500 will cost $26 or $2,600.
But how much protection would one contract provide?
Knowing the contract size will help you determine the coverage needed. At levels of 2,100, one SPX put option will provide $210,000 (2100 x $100) worth of notional value. Therefore, three contracts November 2100 puts will provide a notional value of $630,000.
The same could be applied to a portfolio consisting of European equities – just find out what the multiplier is. On the Saxo Trader platform, the contract size information is displayed on the trade ticket. For the Eurostoxx 50, that multiplier is 10.
The same calculations are applied here:
Portfolio Size/ Strike Price x Multiplier or $500,000 / 2900 x 10 = 17 contracts
Insurance is relatively cheap
With volatility at historically low levels (and equities, bonds, real estate, and more near all-time high) it costs very little to insure a stock or portfolio using any of the above strategies. A small cost for sleeping well and night and making sure you spend more time with the people you love.
Or else you could always stay up worrying about the overseas sessions... Photo: iStock
— Edited by Michael McKenna
Georgio Stoev is futures and options product manager at Saxo Bank