There is a lot of downside risk in both the stock and bond markets at the moment, but with interest rates currently so low I am often asked if there is a way of participating in them while limiting your downside. The answer is yes, and it is not as complicated as most people think. There is a generally misguided fear of anything labelled a derivative, in fact if you scan through the media you will find it is not often you will even see the word derivative unaccompanied by the word complicated. Yet not all derivatives are complicated, and it is a relatively straightforward process to “insure” a portfolio against potential losses.
An American style put option gives the owner the right to sell the underlying stock or stock index at a certain price, the strike price, anytime up until the expiration date. If the price of the underlying stock or index falls below the strike price, the option becomes “in the money” and becomes more valuable as the price in the market continues to drop. Thus, if perfectly hedged, which I will discuss later, you can limit the downside effect on your portfolio to the strike price of the options you hold.
For example, say you own a stock portfolio that is essentially the S&P 500 worth $100,000. You could buy put options at a strike price that is far “out of the money”, for instance 15 percent below where the market is currently trading, and thus lock in a maximum loss on the stock portfolio if 15 percent. Keep in mind you don’t need to buy $100,000 worth of options since they include a lot of leverage. You want to make the number of shares underlying the contracts you buy add up to the value of your portfolio based on the current market price.
The option cost is the sunk cost of insurance basically and should always be viewed this way. If the markets don’t crash these costs are deducted from the return you get obviously like anything else in life the more you spend typically means the more you get, and this is true with options as well generally. An option with a longer time frame to maturity will be more expensive than one with a shorter time frame. The higher the strike price of a put option also means the higher the insurance is going to cost.
Not all stocks have the same volatility as the overall market, so in reality you will not likely put on a perfect hedge. However if you use an option on an index that has similar volatility and is correlated to the bulk of your holdings it will still do well in massively reducing downside exposure. For instance if you hold mostly emerging market stocks like BRIC funds it might not be wise to use the S&P 500 as it will not likely be volatile or even correlated enough to do a very good job. Next week I will write about how you can reduce your risk in the bond markets.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK Pension Transfers. He can be reached at firstname.lastname@example.org. Faramond UK is regulated by the FCA and provides advice on pensions and taxation.