Protecting Your Trades: How Puts Work as Portfolio Insurance

When you buy a new car, you look for insurance on the car. Most states require some form of coverage, but it is usually worthwhile to have it.

When you buy a home, lenders will require you to purchase homeowner’s insurance. While it doesn’t cover everything, it gives you some peace of mind.

While many assets can be insured, most people never think to insure their stock portfolios. This is a shame because it is easy to do using put options.

A put option is an options contract that allows the buyer (you, the investor) to sell shares at an agreed-upon price to another person — even if the stock’s value has fallen. The buyer has until the expiration date (predetermined) to decide whether to exercise the option. This is similar to making a claim on an insurance policy when an adverse event happens.

The dynamics of put options make them perfect for insuring a portfolio. The value of a put increases as the price of the underlying stock decreases. But the premium for the put is a fraction of the price of the stock. In this way, put options behave similarly to insurance policies. 

With puts, the devil is in the details. It isn’t easy to know how much insurance to purchase, i.e., how many puts to buy. Further, should investors purchase puts on the overall portfolio, individual stocks, or both?

Evaluate your portfolio

If your portfolio contains a well-diversified set of safe stocks, you may decide that you don’t need much insurance. It depends on the holding period for your portfolio. All equal, safe stocks are likely to go up in value after several years.

Investors with riskier assets can benefit from buying puts. If your portfolio contains a few risky assets, those would be the candidates for your put-buying strategy. The crucial part is determining how much insurance to purchase and the cost of the puts.

Start small by purchasing a single put on a current position. You’ll need to decide on how long you want the protection. You could try puts expiring within three months. Other dates are available, too.

When the expiration date approaches, evaluate how your stock position is doing. If your stock declined in value, you could exercise your put, or close it out for a gain. Don’t forget to consider the premium when determining your breakeven analysis.

If the stock price rose during the period, you could let the put option expire. If you have a few weeks left before expiration, the option may still have value. You could close out your position for a bit of cash. This action would effectively lower the cost of the insurance premium. 

Another option is to buy a put on the overall market itself. This protects your entire portfolio, to some degree. One way to implement this strategy is to buy puts on an exchange-traded fund (ETF). An ETF is comparable to a mutual fund. However, it can be bought or sold throughout the trading day. Also, many ETFs offer options. 

One popular ETF that tracks the S&P 500 is SPY. You could scan for options on this ETF and choose the parameters that fit your investing style. 

The price you pay for these options will depend on the current volatility of the market. You can use the VIX to measure this. The dynamics of the VIX are beyond the scope of this article.

It pays to keep your strategy simple when buying puts as insurance. Measure the performance to determine if the strategy you chose made sense for your portfolio and your investment goals.

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