Hello again everyone! I hope as I write to you today God is quietly at work preparing you for his next call. I pray we both find the courage to step forward in faith no matter how difficult the direction or overwhelming the request may seem.
That said, it’s well past time for a review of investment portfolio protection using options.
I think you’ll agree the single greatest problem or barrier to investing are those pesky market declines. They come without warning and just randomly wipe away large swaths of wealth. Because of this, millions avoid the investment landscape all together. Truly, it’s unfortunate more aren’t aware of the protective options strategies in existence.
In today’s post I’d like to uncover a few of my favorite options strategies designed to protect an investment portfolio.
Post Agenda
Best Options Strategies for Portfolio Protection
Personal Story
This weekend I had the opportunity to attend my very first horse race and let me tell you it was so much fun! However, at one point I looked over at my cousins wife who was clearly ready to leave and asked her, “Why do you look so bored”? She responded abruptly, “I hate betting!”. I tried my best to tell her she could spend a relatively small sum and still have fun but she just wasn’t interested. To her, putting any money at risk wasn’t worth the reward.
Now, I’m telling you that to highlight this key point as it relates to investing.
She isn’t the only person I know that shares that sentiment. I could probably make a convincing argument that most people, to some degree, share that sentiment. Thus, billions or even trillions of dollars go uninvested because the risk of loss just isn’t worth the reward. In their eyes, they would rather be dead broke because they spent to excess than endure any temporary market decline.
To those of us in the investment space we can clearly see the flaws in this approach. But to the many more just like her they just don’t know what they don’t know. As such, I hope today’s post will shed some light on this far to undervalued investment aspect.
Portfolio Protection
As the title of this segment implies, protecting our portfolio’s should be of primary importance for anyone seeking to invest. Countless are the number of investors who’ve lost money on an investment and ultimately moved on to something else.
Protecting a portfolio can be accomplished in many ways and a few of the common strategies are outlined in this post by Investopedia, “6 common Portfolio Protection Strategies”. However, I’m going to limit my focus here to just a few of the millions of options we have for investment portfolio protection using options.
Honestly, portfolio protection is so often overlooked. As humans, we would rather focus our energy on one of a hundred more important topics. However, doing so means risking literally every dollar of our investment. A risk my cousin’s wife, and millions more, would not be having any part off.
Best Options Strategies for Portfolio Protection
Before we dive in to the purpose of this entire post remember options can be a risky investment. It’s imperative to understand those risks prior to implementing any strategy. That said, once understood and properly deployed they can be the exact tool that minimizes that risk. Kind of funny isn’t it? The thing they told us to avoid is the very thing we need. In any case, here are my top three strategies for investment portfolio protection using options.
Long Put Option
First, the classic put option on a market asset. For those interested, I did a more thorough write up on the strategy some years ago that is still more than relevant. This post will provide a firm grasp on the long put strategy. Have a look at my Long Put post here.
Simply, the long put is placed as a protective measure to an asset decline. For example, assume an investor is concerned Microsoft is nearing a correction point. To account for this they would determine at which level they’ll accept selling their shares and buy that strike price put option.
Remember, a long put option gives the holder the right to sell shares at the strike price. Although, that right doesn’t come for free. The holder would have had to pay a premium for the opportunity to sell their Microsoft holdings for the agreed upon amount.
Here is an example of a Microsoft put option’s payoff diagram.
You can see the loss is limited to the premium paid for the option but the profit to the downside is unlimited. Thus, the reason this strategy is utilized as a protective measure to market declines. Should Microsoft trade below $400 the holder of this option would be able to sell their investment for the strike price at any time.
The long put is generally viewed as the best approach for investment portfolio protection using options because it’s easy and relatively straightforward. However, as I’ve mentioned, the cost to employing this strategy can be high and that will add up over time. Moreover, studies have shown that buying puts can have a dramatic negative impact. So do be aware before implementing the strategy for any duration.
Collar Options Strategy
Easily my favorite options strategy of the bunch. However, anyone seeking to implement the strategy should know there is a fair amount of work and record keeping to be done. That said, if you’re willing, it’s a strategy that guarantees an investment never see’s the red.
For a more detailed review of the collar options strategy, have a look at this article from Corporate Finance Institute. They do a sufficient job of highlighting all the details with an example. Once complete you’ll understand how the strategy performs it’s intended goal.
In this strategy, the investor would determine a price they will accept on both the downside and the upside. Should the price decline to the put strike price they can sell for that amount no matter what happens next. If Microsoft declines by 300 points it would mean nothing to the holder of this long put because they’ll sell their shares at the agreed upon strike price.
Additionally, and building on the single long put. The investor utilizing this strategy would sell a call at a price they would be willing to accept. In doing so, they will have “financed” the purchase of the long put but also capped their upside potential. Should Microsoft rally 300 points the investor would have his shares called away at the less favorable $480 dollar price point.
In all, the strategy has the ability to protect every invested dollar by giving up some of the upside potential. A tradeoff I know many would have gladly accepted during 2008-2009 or through the covid crash.
Put Ratio Options Strategy
Last on our list is quickly gaining more of my attention. Prior to recent education I’d only ever viewed the put ratio spread described here by the Options Industry Council as a directional play. However, in recent weeks I’ve come to view it is possible to create the spread for little to no out of pocket expense.
While I know that sounds fantastic, there is a catch. The risk will need to be assumed for some period of time. Thus, the strategy is intended for those familiar with options.
Regardless of whether the spread is purchased outright or implemented for a net credit is up to the individual investor. The strategy itself still provides the intended protection no matter how it lands in our portfolio.
You’ll first notice the dramatic similarity to the long put strategy mentioned previously. They look similar because this strategy behaves in much the same way. The only difference comes from shorting a put closer to the money to “finance” the purchase of two long puts. What you’re left with is a payoff diagram that has a negative bump just below the short put strike price.
This negative area can be substantial so it isn’t advisable to hold this position until expiration at any time. The intention would be to employ the strategy during a period of bearishness and then remove the position when conditions stabilize.
Additionally, with this spread we’re able to achieve a slightly higher return profile for essentially the same capital cost. With the long put we were paying $525 per contract. The put ratio spread would cost slightly more at $593.
Final Thoughts
To wrap up today’s post, I hope you were able to gain some minimal level of insight into the options for protecting a portfolio. Truly, the options available to protect an investment from loss are infinite using options. While I’ve mostly stayed on the speculative side of the options market I’m finally turning my head to their hedging capability.
When you find yourself entering that phase of your investment journey, I hope you’re considering options. They offer many benefits that other investors are simply unaware even exist and fewer still who would even care. Instead opting for the approach of my cousins wife. Avoiding them all together.
Until the next post.
God bless,
Jeff
