There’s been a lot of banter lately about health insurance and this article is NOT about health insurance, at least not the kind related to doctors, hospitals, Congress, etc.
Individual or Group?
We will examine whether it is better to insure stocks individually or as a group. In an article published several years ago, we explained how to insure a group stocks with index stock options: Portfolio Management: Stock Insurance.
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Covered Call
Today we will look at a portfolio covered call positions which are all members of the S&P500 index and consider how to insure the positions. A covered call position is entered by selling a call option against a purchased stock. The covered call positions examined in this article were all posted by PowerOptionsApplied‘s Titanium TradeFolioTM and closed in December of 2009. The profit/loss diagram for a covered call investing position is shown below:
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Uninsured covered calls have limited upside potential returns and exposure to significant downside losses. A covered call strategy is analogous to purchasing a house and leasing the house with an option to buy. For covered calls a stock is purchased and then “leased out” to an option buyer. The option buyer has the option of purchasing the stock at a predetermined price known as the strike price and with termination of the contract at a predetermined point in time known as options expiration.
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Put Insurance
A covered call or a stock can be insured by purchasing put options. Purchasing a put option is similar to purchasing auto or home insurance. A put option can provide insurance for a covered call in the event the price of the underlying stock decreases significantly. The price of the put option moves inversely to the price of the stock, i.e., if the stock price decreases, then the put option increases and vice-versa.
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Real World Example
The following analysis will be performed assuming the positions are to be insured on December 7, 2009. The table shown below indicates the underlying stock/call option for each covered call investing position and a corresponding put option for insuring the covered call positions against a 10% drop in the value of the underlying stock. Each covered call position has downside protection, generally about 3%, so the covered call positions are actually being insured for a maximum loss of about 7%. The number of shares for each covered call position was chosen in order to position each investment as close to $10,000 as possible. The put insurance is calculated as the price of the option multiplied by the number of shares of stock.
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At $295, the cost of insuring the portfolio of covered calls positions is very expensive and would have taken a big bite out of the $2,255 of profit.
Insuring with Put Options
Instead of insuring each individual covered call investing position, it is possible to insure the investments as a whole or a group with index put options or ETF (Exchange Trade Fund) put options. Since this porfolio of covered calls positions are all components of the S&P500 index we will examine using S&P500 Index options ($SPX), S&P 500 Index ETF options (SPY) and the S&P 100 index options ($OEX) as insurance.
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Insuring with $SPX Put Options
The number of contracts needed to insure a portfolio can be calculated by dividing the total value of the investment by the price of the underlying index or ETF multiplied by 100. For example, to use $SPX index options for insurance on 12/7/2009, the total investment value of $45,779 would be divided by 100 multiplied times the value of the $SPX index which was $1103.25.
$45,779/($1103.25*100) = 0.41 contracts
Performing this calculation results in a number of contracts of 0.41. In this case we would simply round up to the nearest contact which would be one. To insure against a 10% drop in price of the stocks in the portfolio, a put option with a strike price which is 10% less than the value of the index can be selected. The index put option of interested would have been the $SPX December 990 with a price of $0.70 per share or $70 per contract. Since the number of contracts was rounded up, this is more insurance than actually needed, but would be sufficient if there were no better candidates and is much less than the $295 cost for insuring each individual position.
Insuring with SPY Put Options
Another candidate for put option insurance to consider for the portfolio of S&P500 covered call positions is the SPY. The value of the SPY on 12/7/2009 was $110.84 so the calculation to determine the number of contracts is:
$45,779/($110.84*100) = 4.1 contracts
For this case, the number of contracts is 4.1 or rounded down to 4. The SPY put option of interest is the December 100 as it is down 10% from the current price of SPY. The price of the December 100 put option on 12/7/2009 was $0.10. So the cost for the December 100 put option insurance is the price of the put option multiplied by the number of contracts times 100 shares per contract or $0.10 * 4 * 100 or $40. The cost of the SPY put insurance is less than the $SPX insurance and is more close to the level of insurance that we are seeking and also costs much less than insuring each individual covered call investing position.
Insuring with $OEX Put Options
If all of the stocks in the portfolio were components of the S&P100, then we could have evaulated using the $OEX index put options for insurance. For example, the price of $OEX on 12/7/2009 was $512.45, so the amount of contracts needed would have been caculated as:
$45,779/($512.45 * 100) = 0.89 contracts
To insure with $OEX put options would require 0.89 contracts, which would be rounded up to one contract. The put option of interest would be the December 460 with a price of $0.40. The cost of $OEX put insurance would have been $0.40 * 1 * 100 or $40, the same cost as for the SPY put option. However, the bid/ask spread for this option was $0.10, so using a limit order we might have been able to purchase the insurance for $0.35 per share or $35, slightly less than using SPY put options.
Testing the Strategy
It is always a good idea to test a strategy to see how it would perform. For example, assume after purchasing the put option insurance, the aggregate stock market were to drop 20%. We’ll assume the underlying stocks for the covered call positions also drop 20% and result in a stock-component loss of $9,156, however each of the covered call positions had downside protection of 3%, so the actual loss of the covered call portfolio would have been 17% or about $7,782.
A 20% drop in the price of the $SPX would translate into a price of $883. After the price drop for $SPX, the price of the $SPX December 990 put option would be worth around $107 ($990-$883) or $10,700 ($107*1*100) for one contract. As was indicated above the $SPX December 990 put option was more insurance than needed as we ended up with a profit of $2,918 ($10,700 – $7,782). But maybe having a little extra insurance is a good strategy, not bad for only $70 of insurance.
A 20% drop in the price of the SPY ETF would have resulted in a price of $88.67 for SPY, so the value of the December 100 put option would be worth about $11.33 ($100-$88.67) or $4,532 for 4 contracts ($11.33 * 4 * 100). In this case the loss for the covered call portfolio would be -$3,250 ($7,782-$4,532) or a loss of about -7% ($-3,250/$45,779). Pretty good insurance for only $40.
The previous example was for insuring a portfolio of covered calls for 12 days. The portfolio could have been insured for the entire month beginning on November 23, 2009 by purchasing the SPY December 100 put option for $0.29 or $116 ($0.29*4*100).
A similar portfolio could be insured in a like manner today for 18 days using the SPY January 102 put option with a price of $0.15 which would cost $60 ($0.15*4*100).
This type of insurance protects against general market downdrafts and does not protect against an individual position heading south. For a portfolio of covered calls with the potential to generate 3%, it is quite cost effective to insure the portfolio with index or ETF put options, much more cost effective than insuring each individual position.
[tags] health insurance, doctors, hospitals, Congress, $OEX, S&P 100 Index, $SPX, S&P 500 Index, SPY, S&P Depositary Receipts Trust ETF [/tags]