The conventional approach for protecting a portfolio against a large loss, research, buy-and-hold and diversification works well for singular events like an Enron or a Worldcom. However, for systematic market problems this approach can be very painful, as the stock market can drop significantly with very few stocks maintaining their value.
The stock market can behave crazily at times as in the case of Technology Bubble, Lehman Brothers, Housing Bubble, Credit Crisis, Debt Ceiling, etc. Investors can be taken for very painful rides during market events such as these.
|Sign up now for PowerOptions 14-day free trial|
(to view archived version of this presentation click the video below)
An investor would not consider owning an expensive house or automobile and also not have it insured, however, the same investor may think nothing of putting his/her capital into the stock market – without any kind of insurance.
| See what the stock option experts are doing |
Sign up now for PowerOptionsApplied 30-day risk free trial
But, where would an investor purchase insurance for their investment portfolio? The answer is the option market. The option market provides several methods for insuring an investment portfolio. Four of the methods discussed in this article include:
These four alternatives, individual, ETF, index and VIX, provide investors with a variety of ways for insuring their portfolios. Each approach has its positives and negatives, but all may be used for insuring an investment portfolio.
Put options for stock enable insuring a single investment against a loss. ETF put options can provide insurance for a sector of stock investments or a broad market of stock investments. Index put options and VIX call options can provide insurance for a broad market of stock investments.
| Free portfolio insurance newsletter |
» protect your investments
» sleep at night
Individual Put Options
Put options for individual stocks provide the highest level of protection, but also come with the largest cost. This cost can include higher brokerage fees as well as the associated “cost” for insuring the investment. The cost for insuring an individual stock varies depending upon the “level” of insurance, but typically costs around 1.5% per month or 18% per year. This means in an up market, an investor would have to make at least 18% on an investment just to make a profit. Individual put option insurance can be entered for weekly (in some cases), monthly, quarterly and yearly increments. In general, individual put options further out-in-time provide the cheapest insurance based upon cost-per-day, but require the largest upfront capital and/or cost.
| Free stock option newsletter |
» return goal > 2% / month
» works in any market
ETF Put Options
ETF put options enable an investor to insure a sector of stock investments. For example, a portfolio with a large portion in oil and gas related companies may be insured using an oil and gas oriented ETF. Using ETF put options for insurance enables an investor to focus on a particular sector and not be significantly hurt if the sector takes a hit. However, a problem with an individual stock and not associated with sector as a whole can cause some pain for a portfolio insured with ETF put options. However, by using the conventional approach of diversification, a hit from a single investment can be reduced. Similar to individual put options, ETF put options further out-in-time provide the cheapest insurance based upon cost-per-day, but require the largest upfront capital and/or cost.
| Want to protect your portfolio/401K from market downside? |
yet still benefit from market upside
Sign up now for the free Sketch
Index Put Options
Index put options can insure a broad-based portfolio of investments. If the whole market takes a hit, index put options can provide insurance. However, similar to ETF put options, a problem with an individual stock not associated with the market as a whole can cause some pain. Diversification, as discussed in the previous paragraph, can help reduce problems with a single investment. Similar to individual put options and ETF put options, index put options further out-in-time provide the cheapest insurance based upon cost-per-day, but require the largest upfront cost
| Learn how to profit from winner stocks |
and protect yourself from loser stocks
Download free Trade Simulator now
VIX Call Options
The VIX index represents a measure of the implied volatility of S&P 500 index options. The VIX moves counter to the stock market, if the stock market moves down significantly, the VIX moves upward significantly. VIX call options provide insurance for a broad-based portfolio, similar to index put options, however, when the market has a lot of “fear”, VIX call options can provide some very serious protection for a small amount of capital. As an example, a broad-based investment portfolio can be insured with VIX call options for about 0.5% per month. Based on this example, a $100,000 broad-based portfolio of stocks can be insured with VIX call options for $500 per month. However, insuring with VIX call options require monthly purchases of the options, as VIX call options further out in time do not move very much as compared to the stock market. Purchasing VIX call options with a short time-to-expiration is preferable, as the shorter timeframe VIX call options move more dramatically when the market makes a significant movement. The graph below illustrates the contrary movement of the VIX as compared to the S&P500 index (SPX):
| Learn to trade like the pros |
Signup for free Webinars now
As can be observed, the VIX moves contrary to the stock market. When the market moves up, the VIX moves downward. When the market moves down, the VIX moves up. Purchasing a long call option provides a hedge mechanism for alleviating pain when the market takes a very large drop.
Investment Insurance is Expensive
Investment insurance by itself presents a problem, as it is expensive. As a conservative example, insuring with VIX call options can require as much as 0.5% to 1% of a portfolio per month or 6% to 12% per year. So, a $100,000 portfolio requires from $500 to $1000 per month to insure with VIX call options. Individual stock put option insurance is typically more expensive than VIX call options with a cost in the neighborhood of 1.5% per month.
The long-term return of the stock market is in the range of 8-10% per year, so a buy-and-hold investment approach attempting to use insurance for protection does not bode very well for realizing a profit after paying for the insurance. For example, a portfolio returning 8% per year with an insurance cost of 6% per year leaves only a 2% margin for profit.
Income Methods to Pay for Investment Insurance
With the stock market being too volatile and insurance being too expensive, what is the answer? One approach is to purchase insurance and pay for the insurance with income methods. Another approach is to invest with option income methods and use a portion of the income from the income methods to pay for investment insurance.
As a reference, some examples of income methods include:
The Covered Call income method will be discussed in more detail later in this article. The Naked Put strategy has a similar risk/reward profile as the Covered Call, but does not involve purchase of stock and therefore does not participate in receiving dividends. Investing in Spreads is a highly leveraged strategy and is not discussed in this article, but in general, it is recommend to overly weight a portfolio with Spreads, as Spread positions can be very dangerous and can result in a large loss in highly volatile markets.
Purchase Insurance then Pay for Insurance
Purchasing insurance followed by paying for the insurance with income methods can be performed via the Married Put position. A Married Put combines purchase of a stock with purchase of a put option. The shares of the stock are insured by the put option. The put option provides a guaranteed exit.
An example of a 5-line setup for Married Put position is shown below:
Insurance for Single Stock is Very Expensive
The Married Put position is a limited risk position with unlimited upside, however the insurance provided for protection is expensive. In the case of the ABX example, the insurance costs about 1% per month. However, income methods can be used to reduce and/or eliminate the cost of the insurance. It is also possible to realize a position which is “Bulletproof” meaning a position guaranteeing an exit price higher than the initial cost basis. For example, the initial cost basis for the ABX position was $57.81, so bulletproofing the ABX position would result in an exit price greater than the initial cost basis of $57.81. The chart below illustrates a profit/loss diagram for the initial ABX position:
As an example scenario for ABX, consider the possibility of selling a Sep 55 call option for $3.00 after the price of ABX increases to $55. Selling the call option against the stock is known as a Covered Call position and the Covered Call position combined with the put option results in a Collar position. The Covered Call and Collar positions are discussed in more detail later in this article.
Selling the Sep 55 call option reduces the risk to -$0.19 as the total cost for the ABX position has been reduced to $54.81 with a guaranteed exit price of $55 – the position has been made Bulletproof – meaning it cannot result in a loss as compared to the initial investment! A profit/loss chart for the modified ABX position is shown below:
The details for the Married put with Income strategy can be found in “The Blueprint” – additional details can be found at www.RadioActiveTrading.com. A free “Sketch” can be downloaded at RadioActiveTrading outlining one of the ten income methods discussed in “The Blueprint”.
Pro’s of the Married Put with Income Strategy are:
Con’s of the Married Put with Income Strategy are:
The Covered Call investment strategy is one of the most well-known and most popular stock option strategies. Many stock option investors start with Covered Call investments and then learn more advanced stock option investing strategies.
A Covered Call position may be entered by purchasing a stock and selling a call option against the stock. A Covered Call position may also be entered by selling a call option against an existing stock position.
A Covered Call position can be considered analogous to purchasing a house and leasing the house out with an option to purchase.
A profit/loss diagram for a Covered Call position is shown below:
As illustrated in the profit/loss chart shown above, a Covered Call position has some downside protection, so the price of the stock can drop with the position remaining profitable.
Covered Call Can be Managed
A negative of the Covered Call strategy is its limited upside potential and its exposure to a very large loss. However, application of management techniques for the Covered Call strategy increases the cap associated with the upside potential. Covered Call positions can be rolled up, down, and/or out-in-time for increasing upside potential. An example of a managed Covered Call position is shown below:
A Covered Call position can be converted to a Collar position with the purchase of a put option. A Collar is analogous to purchasing a house, leasing the house out with an option to purchase and purchasing insurance for protection.
A profit/loss diagram for a Collar position is shown below:
As can be seen, the Collar position has limited upside and downside.
Example Covered Call Trade
An example for the PowerOptionsApplied Titanium TradeFolioTM will be presented illustrating the management of a Covered Call position. Titanium is a newsletter publishing Covered Call positions for stocks with 2-8 new positions entered per month with an average number of twenty positions open at a time.
Titanium uses its sister company, PowerOptions (www.PowerOpt.com), for finding and managing Covered Call positions. Typically positions published by Titanium are: included in S&P 500, in an up-trend and have recently taken a dip
PowerOptions’ tools enable searching for positions meeting the three criteria mentioned above. Positions in an up-trend are found by searching for positions with a 100 day moving average greater than the 200 day moving average. Positions which have also taken a dip are found using Bollinger Band constraints.
A position for Kohl’s (KSS) was found using PowerOptions on 1/10/2011. The price of Kohl’s stock was also close to its 200 day moving average and its previous support level, two other desirable conditions for entering a Covered Call.
A profit/loss diagram for the published KSS Covered Call position is shown below:
Kohl’s stock was purchased for $52.03 and a 2011 Feb 52.50 call option was sold against the stock for $1.37.
The unchanged potential return for the Kohl’s Covered Call position was 2.7%, the assigned potential return was 3.6% and the time-to-expiration was 40 days. The unchanged potential return of 2.7% represents the potential return if the price of Kohl’s stock was at the price of entry, $52.03, at expiration. The assigned potential return of 3.6% represents the potential return if the price of Kohl’s is greater than the strike price of the call option, $52.50, at expiration, resulting in the assignment or calling away of the stock.
Covered Call vs. Collar
As a hypothetical comparison, entering a Collar for Kohl’s can also be analyzed. For example, the KSS 2011 Feb 50 put option could have been purchased on 1/10/2011 for $0.75. The Collar position would then have had an unchanged potential return of 1.2%, an assigned potential return of 2.1% and a maximum risk of 2.7%. Purchasing the put option for insurance limits the downside for the position to 2.7%, but does so at a cost of 1.5% of potential return. A comparison of the Covered Call position versus the hypothetical Collar position is shown in the table below:
Rolling Covered Call
On 2/17/2011 very little time value was left for the Kohl’s covered call position and the position was rolled to a new position. Time value represents a premium over the intrinsic or current exercise value. The details for rolling the position are shown below:
By rolling the position from February to March the new assigned potential return was 5.4%. As a bonus, on 3/7/2011 Kohl’s paid a dividend of $0.25 per share increasing the assigned potential return to 5.9%.
On 3/18/2011, the price of KSS was at $52.77, so the March 52.50 call option was in the money and the KSS stock was assigned or called away. The table below compares the return for the covered call position versus a buy-and-hold long position in KSS:
Covered Call Outperformed Long Position
As you can see, the Covered Call strategy outperformed the buy-and-hold strategy by 4%. This is not always the case, sometimes the Covered Call position outperforms a buy-and-hold stock, and sometimes the buy-and-hold long stock outperforms the Covered Call. The real advantage of using the Covered Call strategy is that income generated from selling the call option can be used to purchase insurance for insuring a single position and/or for insuring a portfolio.
Income investing with insurance provides income with less volatility, so investors can invest with less fear.
Investors seeking to learn income investing with insurance can get started with a free 14-day trial to PowerOptions at www.PowerOpt.com. PowerOptions provides education and tools for income investing with insurance. PowerOptions also provides tools for analyzing, finding and managing income generating investments.
Investors seeking to follow the experts for income investing with insurance can get started with a subscription to a free newsletter at www.PowerOptionsApplied.com.
Safety Net is included with a subscription to the free PowerOptionsApplied newsletter. Safety Net is provided to help investors insure their income generating portfolios against a large market crash. The table below compares some hypothetical best-case returns for insuring with SPY put options versus VIX call options (used by the Safety Net):
As can be observed, VIX call options significantly outperformed the SPY put options in three of the four examples Lehman Credit Crisis part I, Lehman Credit Crisis part II and the Flash Crash. However, in the recent market drop associated with the Debt Ceiling political maneuvering, the SPY put options outperformed the VIX call options.
Hypothetically, an investor purchasing the VIX Oct 60 call option on 9/22/2008 and selling the VIX Oct 60 call option on 10/17/2008 would have experienced a return of 11700%. For example, for a portfolio of $100,000 and using 0.5% or $500 of the portfolio for insurance would have realized a gain of $58,000. A diversified portfolio of S&P500 stocks would have dropped around $23,000 over the same time period. So instead of the portfolio being down $23,000, the portfolio would actually have realized a gain of $35,000 ($58,000 – $23,000) due to the VIX Oct 60 call options.
A difficulty with purchasing insurance using VIX call options is determining which VIX call option to purchase. The best return was generated for a VIX call option selected 26 strikes out-of-the-money, however selecting a VIX call option 26 strikes out-of-the-money only works well when the market is really volatile and fearful. In general, its best to purchase short-term VIX call options with a time-to-expiration of less than 30-40 days and 4 to 8 strikes out-of-the-money. An investor might also consider using half of their insurance allocation for purchasing VIX call options 4 to 8 strikes out-of-the-money and half of the allocation for purchasing VIX call options about 20 strikes out-of-the-money.
If after reading this, you think income investing with insurance is for you then check out our websites at: www.PowerOpt.com, www.PowerOptionsApplied.com and RadioActiveTrading.com. Don’t forget to sign up for the free 14-day trial to PowerOptions, the free newsletter to PowerOptionsApplied and get the FREE “Sketch” at RadioActiveTrading.com.
[tags] portfolio, diversification, stocks, Technology Bubble, Lehman Brothers, Housing Bubble, Credit Crisis, Debt Ceiling, Investors, insurance, KSS, Kohls Corp. [/tags]