• Option contracts can help investors can hedge downside risk when the potential for market loss is elevated.

• The expense associated with using options to establish a hedge can also be a drag on portfolio performance if the market subsequently heads higher.

• Whether option-based portfolio insurance makes sense for you depends on your investment objectives and market conditions.

“Energy cannot be created or destroyed, it can only be changed from one form to another”  — Albert Einstein

For the past several months, a world war has been wedged against the COVID-19 virus. Encouraging signs of progress on the medical front of this war has led to a large number of predictions regarding how the battle will play out on the economic front.

McKinsey & Company recently published an illustration of various possibilities for the direction the economic recovery might take.

While these types of illustrations are helpful, anyone who claims to know for sure which course the U.S economy will take in the weeks and months ahead is either lying or kidding themselves.

In an unstable economic environment, option contracts can help investors can lessen downside risk.  A “stock option” is a right to buy or sell stock (or ETF shares) at a pre-determined price on or before the “expiration date” specified in the option contract.  Listed options are sold on regulated exchanges, such as the Chicago Board Options Exchange (the “CBOE”), in much the same way that stock is traded on the New York Stock Exchange. 

There are two types of stock options contracts.  “Puts” give the person who purchases the contract (the “holder”) the right to sell the stock at a specified “strike” price to the person who sells the call option (the “writer”) on or before the expiration date. “Calls” give the holder the right to buy the stock from the writer at the strike price on or before the expiration date. 

Stock options can limit the harm that would otherwise be triggered by a stock market decline. That being said, stock options come at a cost. There’s an expense associated with the acquisition of options, or the cost associated with the lower returns that will result if the risk being insured against never materializes, or both. As Einstein might have said, had he been an investment advisor: Investing risk cannot be created or destroyed, only transformed.

Accordingly, I believe portfolio insurance is best suited to intermittent use when market risk is high.

A key consideration when deciding how best to use option contracts to provide portfolio insurance is the cost of implementing hedge under consideration.  Comparing an option contract’s market value to its theoretical value can give an investor a good indication of how expensive an option contract is in relation to the degree of protection it affords the holder.  An option’s theoretical value is the option’s true worth based on a mathematical model, independent of the prevailing psychology or mood of participants in the options market at the time the option contract is being valued.

The following is a description of four of the numerous option strategies that can be used to hedge against a market bubble.

• Remain Invested and Buy Protective Put Options. This technique involves buying put option contracts on selected securities held in your account.  A put establishes a floor on the amount that the stock can be sold for equal to the strike price specified in the option contract.  However, such a strategy can be costly, especially in the long term.
• Buying Broad Market Index Put Options. This strategy involves buying put option contracts on a broad market index such as the S&P 500.  The hedge provided by this strategy results from the value of the put options increasing if the index falls. 
• Remain Invested Sell Call Options. This strategy involves selling call options on ETFs held in your account.  With this strategy the hedge is provided by the option premium collected on the sale of the call option contracts.  However, it also establishes a hard cap on the return that can be generated while the contracts remain in effect. 
• Fund Selected Asset Allocations with Cash Covered Put. This strategy is particularly useful when put options are priced above theoretical values.  It involves selling selected securities that would normally be held in the portfolio, and at the same time selling a put contract on that position. 

If the put expires “out of the money” (i.e. the price of the stock does not fall to the strike price during the term of the put contract) the investor keeps the option premium and is in position to re-sell the put option and to collect another premium.  If the stock price drops below the strike price, the investor can repurchase the sold security at the lower price, and again keeps the option premium.  However, if the stock rises after the position is sold, then the investor misses out on those gains.

• Fund Selected Asset Allocations with a Synthetic Long Stock Combination. A synthetic long stock position also involves a combination of put and call option contracts, but in this case, the covered security is sold, and call options are purchased to take the place of shares sold, with a strike price at or near the sale price.  A put option is also sold on the stock that was sold, with a strike price below the current market price. The premium collected on the sold put contract offsets (at least partially) the cost of the call option.

If the stock price of the sold security rises above the put price, then the call option allows the investor to repurchase the sold security at the price at which it was sold.  If, on the other hand, the stock falls below the sale price of the stock that has been sold, the sold stock can be repurchased at a lower price. 

A hedge that is intended to insure against the possibility of an equity market bubble will typically remain in effect for intervals of 3 to 12 months.  However, current market conditions, as well as the particular hedging strategy selected, will affect this determination.

Whether option-based portfolio insurance makes sense depends on a number of factors, including the investor’s investment objectives and risk tolerance, economic outlook and market conditions. 

It is also important to recognize that all forms of portfolio insurance come at a cost, whether that be an amount spent up-front to establish the hedge or the opportunity cost associated with the lower returns that will be experienced if the covered risk never materializes.  The same can be said about more traditional forms of insurance. 

I don’t feel that the yearly premium paid for homeowners’ insurance was a bad investment if my house never burns down.  But I do pay close attention to the amount of the premium and what’s covered by the policy. The same is equally true when using option contracts to obtain portfolio insurance.