Imagine you had a plain vanilla $1 million equity portfolio that was solely invested in the S&P 500 and you were starting to feel a little nervous about stocks because of high valuations or deteriorating earnings estimates. How would you go about protecting yourself if stocks began to decline in earnest? Put options come to mind as a good choice but would buying puts be a viable option for "insurance" purposes? The always insightful Meb Faber Research posed a similar question last week that inspired this exercise.
Let's assume you thought a 20% decline by the end of the year had a decent probability of occurring (we started this exercise before the afternoon ramp yesterday in the S&P 500 so we will assume that the S&P 500 is currently priced at a nice round number of 2000). The simplest way of protecting yourself would be to buy some at-the-money puts that expire in December. At the time of writing this exercise, a put option on the S&P 500 for a Dec 19th, 2015 expiration at a strike price of 2000 was priced at a bid-ask spread of $144.80-$147.40. S&P 500 options use a multiplier of 100 so the cost of one put option (using the asking price) would be $14,740 ($147.40 * 100 multiplier).
Ok, now that you know how much one option would cost how many options would you need for your "insurance" purposes? The notional amount of a single put is $200,000 (2000 * 100 multiplier). Thus, you would need to buy 5 puts in order to cover your million dollar portfolio. Therefore, your total cost of insurance is $14,740 * 5 contracts = $73,700 or 7.37% of your total portfolio. The breakeven level for the S&P 500 in this scenario would be 1852.60.
Keeping things simple, let's imagine that on December 19th, the S&P 500 has fallen exactly 20% to 1600. Your portfolio is now only worth $800,000. However, your gain on your put options is equal to the decline in the index minus your put option premium. The puts themselves are worth $200,000 ((2000-1600)*100 multiplier *5 contracts) minus the cost of the puts ($73,700). Thus, your total portfolio would stand at $926,300 or down 7.37% (instead of down 20%). Would you be willing to pay 7.37% for "portfolio insurance"? To us, it seems quite expensive even in this low volatility environment.
Ideally if you made this trade, the decline in stocks would happen immediately and therefore you could sell your positions at a nice profit as the "time" portion of the option price remains high and the volatility component of the price increases the price of the put option as well. If you felt more certain a decline would happen, you could try to capitalize on it by buying some out-of-the-money puts. Currently a 10% out-of-the-money put would cost about half as much to own, about 3.75%. Unfortunately, however, even though volatility is relatively low put options remain a pricey insurance option for investors at the moment.