How to use Options as an Insurance Policy Against a Market Downturn
With major stock indices near their all-time highs, company valuations far north of historical averages, and interest rates set to rise, concerns of a stock market bubble are intensifying.
That being said, predicting a market top is an almost impossible task, but if someone wanted to protect against a potential downward move in the market, without actually selling their current holdings, there is a way to use options as a form of an insurance policy. To do this, one could consider buying a put option as a hedge since it would increase in value if the underlying asset decreases in price. Also, given that options have embedded leverage in them, you will gain a much higher return on the put option in a downward moving market.
Again, using a put option as a hedge is very similar to buying an insurance policy on your home. When you buy a home insurance policy that doesn’t mean that you are hoping for your house to burn down, you would hope that you never have to use the benefits of that policy, but it helps you sleep a little better at night knowing you have that protection. Buying a put option will give you similar protection on a long equity portfolio, giving you some protection if the market burns down, but ideally that doesn’t happen and your long portfolio continues increasing in value.
Using a more tangible example, picture that you own 100 shares trading at USD 200 and you predict the price to fall to USD 190 sometime over the next 30 days. To hedge your position you decide to buy a USD 200 put option for USD 6.5 with a multiplier of 100, equaling a total price of USD 650. Given various stock price scenarios in the coming 30 days, your P/L will develop accordingly as illustrated below. Note that you can’t lose more than what you paid for the option, which in this case is 3.25% of the portfolio value (6.5/200).