Keep Your Retirement On Track with Put Options
If you could buy an insurance policy on your investment portfolio that made you whole if losses exceeded a specified amount, would you be interested?
Believe it or not, you can create your own insurance policy that does exactly this using a security called a “put option“.
OK, some of you who are reading this may be turned off by the idea of playing with derivatives, which are often characterized as high risk investments. However, please continue reading and I am sure you will see they can be used to reduce the risk of an investment portfolio.
A put option is a type of derivative security (in other words, its return is derived from the return of another security or index) that gives the holder the right to sell an asset (for example, shares of IBM stock) at a defined price within a defined time period.
When the put option is held along with the asset (called a “covered put option strategy”), the option “locks in” a minimum selling price for the asset during the period in which the put option is active. For example, if I owned 100 shares of IBM stock, and the current share price was $100, I could buy one year put options with a “strike price” of $100 that would give me the right to sell my shares at this price at any time during the year.
If the share price drops below $100, the put options become valuable because I have the right to sell the shares at a price that is greater than the current market price of the shares. In option speak, this is referred to as being “in the money”. The gain that is realized from the option offsets the losses that I incurred on my IBM shares, making me whole.
For example, suppose the IBM shares drop to $75. My original portfolio which was worth $10,000, is now only worth $7,500 at current market prices. However, because I have secured the right to sell them at $100 a share, I can still get $10,000 for them. Alternatively, I can sell the option just before the exercise date for a price that should be close to $2,500 (the difference between the strike price and current share price), which will result in a portfolio of $7,500 in IBM shares and approximately $2,500 in cash.
Sounds interesting? Here are some answers to questions you may have about this financial strategy.
Frequently Asked Questions
The idea of getting rid of my downside risk is appealing, but quite frankly it sounds too good to be true. What’s the catch?
The catch is that you have to pay for them, just like you have to pay for an insurance policy. In our simplistic example above, we ignored this – in reality we would not be made entirely whole on our loss because we incurred the cost of the put option when we purchased them.
What affects the price of a put option?
The price of a put option will depend upon the following:
- The current price of the “underlying security” (in our example above, this was the IBM stock). Everything else being the same, the lower the current price of the underlying security the more expensive the put option will be.
- The strike price of the put option. Everything else being the same, the higher the strike price the more expensive the put option will be.
- The volatility of underlying security. The greater the volatility, the greater the probability that the share price will decline, putting the put option “in the money”. Therefore, everything else the same, the more volatile the underlying security, the more expensive the put option will be.
- The exercise date (that is,the date at which the option expires). Everything else the same, the later the exercise date the more expensive the put option will be.
- Interest rates. Because there is some time value involved, the value of the option will be affected by interest rates. Everything else the same, the lower interest rates are the more expensive the put option will be.
Is there more than one type of put option available for a given underlying asset?
Yes. Typically, you can purchase options with different strike prices and exercise dates.
How long of a duration do put options generally have?
Exchange traded put options generally have an exercise date that is one year or less.
If the price of a put option is more than I want to pay, is there a way I can adjust the protection to lower the cost?
Absolutely. There are a few ways of doing this. First, you can buy put options with lower strike prices – this is similar to increasing the deductible on an insurance policy because you are increasing the amount of loss that you are wiling to absorb before the “insurance” begins to payout.
Second, you can protect less than 100% of your portfolio by purchasing fewer options than you would otherwise have to.
What happens if the share price of the underlying asset never drops below the strike price?
The same thing that happens when you buy fire insurance on your home and you don’t have a fire – the “insurance policy” you bought (i.e. the put options) will expire without value. So, you will have paid a price for protection that, with the benefit of hindsight, you did not need.
OK, I like this idea of using put options to protect my nest egg, but can I buy a put option on any asset? If not, what kind of investments have options?
Another great question. The answer is no, options are not readily available on any asset – for example, you cannot buy an option on a mutual fund. If you are an indexed investor, put options are available on several indices and indexed exchanged traded funds. Options are also generally available for most exchanged traded stocks.
So, it sounds like indexed investing is better suited for using put options because of the convenience and simplicity. Would this be another reason to become an indexed investor?
Yes. In addition to the convenience (vs. having to buy a put option for each stock held within a diversified portfolio) the put options will also be slightly less expensive because of a “correlation discount.” In other words, if you think of an index fund as a basket of stocks that are included in the index, some stocks may decline while others may increase in value – if the gains on those stocks that increase in value are greater than the losses on those stocks that decrease in value, you really don’t need the protection from the put option. If you purchased put options on each stocks, you would get a payout on those that decreased in value that you don’t really need – by instead purchasing a put option on the entire index that only pays out when the losses on stocks exceed the gains on stocks, it will be less expensive.
Where can I buy put options?
You can purchase exchange traded options through a brokerage account, similar to how you buy and sell stocks and other securities. However, because trading stocks can involve certain risks most brokerage firms require you to receive special approval to trade options. You will probably have to provide information that describes how you intend to use them and your familiarity with their risks; the brokerage firm will then give you certain access to trade options, possibly with certain restrictions.
Is there a risk that whoever owes me money under an option arrangement reneges on their promise?
Generally, no. If you purchase an exchange traded option (which you probably would), there is a clearinghouse, called the Options Clearinghouse Corporation, that is responsible for making sure that all options are appropriately executed and settled as defined by their terms. Therefore, the risk of the “counterparty” to the put option (i.e. the party that sold you the put option and that is obligated to buy the asset at the agreed upon price) reneges is mitigated by the existence of the clearing house that stand between each party. For the put option to fail to deliver, the clearing house would have to fail, which is generally viewed as unlikely due to close regulatory oversight.
What happens when the option reaches its exercise date and the share price is less than the strike price? Do I need to do something to get paid, or does it happen automatically?
The ways in which you can settle an option will vary depending upon the services that your broker provides, but many do offer an”automatic exercise” service that you can elect which, as its name suggests, will automatically transfer the shares and cash at the exercise date. Options can always be bought and sold prior to settlement, so if you prefer to not execute an exercise you can always sell the put option for a value close to the difference between the strike price and share price.
This doesn’t sound too bad – why are options and other derivatives portrayed as risky investments?
They can be risky when used in a manner different than what is described in this article. More specifically, “covered option” strategies are not that risky because gains and losses on the options are typically offset by a gain or loss on the underlying asset that you also own. However, when options are held without the underlying asset, known as a “naked position”, investors run the risk of experiencing significant gains and losses.
Suppose in our example we bought the IBM put options without owning the IBM shares – if the price of IBM shares never fell below the strike price the option would expire with no value and, if this were your only investment, you would lose all of your savings.
John Bevacqua on November 18, 2011