Saxo Group
Summary: Returns and risk are always interlinked when trading stocks. While no one truly knows if we are at a market top, there are things you can do to limit downside risk if you do have concerns. One strategy is to use options as a form of an insurance policy. Below we explain what an option is and how you can use a put option to protect your portfolio value from a potential market drop.
What is an option?
An option is a financial instrument based on the value of an underlying security such as a stock. When buying an options contract you’re paying for having the option to buy or sell the underlying security within a specific timeframe. I.e. you’re paying for the option to buy or sell an asset within a given period of time, at a specified strike price, but are not obliged to.
There are a few key components of an option contract that you need to understand:
Strike Price: The price at which the underlying instrument will be bought/sold if an option is exercised.
Expiration Date: The last date on which the holder of the option may exercise it.
Multiplier: The number of assets an option contract can be converted into.
Let’s now look into the different types of options, calls and puts.
Call options: when buying a call option, you’re paying a premium for having the opportunity to buy a specific asset at an agreed-upon price within a given period of time. Generally speaking, if the underlying asset rises in price, so will the value of the underlying call option. If the underlying asset is above the strike price at expiration date then the holder of the option may choose to exercise the option to buy the shares at the lower agreed-upon strike price or sell the option at a profit. If the underlying price is lower, then the option would expire worthless at expiration date. Below we will show an example of how this works with a strike price of USD 40 and a premium of USD 200.
Put options: when buying a put option, you’re paying a premium for having the opportunity to sell a specific asset at an agreed-upon price within a given period of time. Generally speaking, if the underlying asset lowers in price, the value of the put option will actually rise in price. If the underlying asset is below the strike price at expiration date then the holder of the option may choose to exercise the option to sell at the higher agreed-upon strike price, or just sell the option at a profit. If the underlying price is higher, then the option would expire worthless at expiration date. Below we will show an example of how this works with a strike price of USD 40 and a premium of USD 200.
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).
If you want to hedge a broader portfolio exposure, you may consider buying an option with an index as underlying. Assuming a portfolio with a diverse US market exposure, you decide to create a hedge by buying a put option (135 days expiry) on S&P 500 with a strike price of USD 3,640, which’s 95% of S&P 500’s current price. The premium of such protection is 3.9%, meaning you have bought the option to, within 135 days, sell 95% of S&P 500’s current value for the price of 3.9% of your portfolio value.
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