Interview with Mark from Options for Rookies

by Manshu on January 25, 2010

in Investments

I requested Mark from Options for Rookies for an interview while I am away, and he very gracefully accepted. In this interview Mark explains how options can be used as insurance for your portfolio. If you have any questions, please leave a comment here, or at Mark’s blog. As far as I can tell, Mark responds to each and every comment, and your answer will very likely get answered.

1. You have often said that options are a good way of insuring a portfolio. In your opinion – is buying Put options or selling Futures a good way to do this for a rookie? Is there a better way?

Conservative option strategies allow for earning substantial market profits – with reduce risk.  As a trader becomes more conservative  – and increases portfolio protection (insurance), stricter limits are placed on potential profits.  The ideal situation is a good balance between minimizing losses and earning profits.

The problem with buying insurance – as a stand alone strategy – is that there is always the negative side.

1) Buying put options is just too expensive.  It does it’s job very well and protects the investor from all disasters.  As with any insurance policy, the individual can choose his/her own deductible.  For example, when a stock is $52, you can buy a put option that gives you the right to sell shares at 50 (The most you can lose is $200 plus the cost of the puts); 45 ($700 max loss, plus put cost) etc.

Put options cost so much, that there is usually little chance to profit when the market continues to rally.  Expect to pay at least 15 to 20% of the stock price – per year – for this type of insurance.  I do not recommend it.  Too expensive.

2) Selling futures does provide a good hedge.  If that’s not bad enough, there is a big correlation risk.  If an investor’s portfolio under performs the futures contact, then significant money can be lost on rallies.  That is not the purpose of owning insurance.  It’s best to avoid correlation risk by owning insurance on the specific investment that you already own.  Do not sell futures as a stock market hedge.

3) The method I prefer costs very little (sometimes you can be paid for owning this insurance) cash, but there is an opportunity cost.  This strategy is the collar, in which you do buy the put option per #1 above – but you also collect cash for selling a call option.

This is the mixed blessing.  Selling the call often provides sufficient cash to pay for the put option – with cash left over.  But, your upside potential is limited.  When you sell the call option, you sell someone else the right to buy your shares – if those shares are priced above the call strike price when option expiration day arrives.  Thus, profits are limited.

I’m willing to trade the ‘potential’ upside for the ‘guaranteed’ protection.  Many investors are not willing to make this trade.  Being afraid to miss a rally, they prefer to take the risk of getting hurt in a down market as long as they have the possibility of earning unlimited upside profits.  Who is to say that’s wrong?  It’s far too risky for me, but each trader makes his/her own decisions.

2. How does one go about evaluating the cost for such insurance?  At what time do I need to say I will just sell my stocks instead of buying (or selling) these options or future positions to protect my portfolio?

To evaluate the cost, take a look at option prices.  If you plan to buy puts, pick the strike price, look at a 3-month put and see the cost.  Then multiply by 4 to give you a reasonable estimate of what it will cost to insure this position for one year.  Most of the time you will discover that the price is just too high and the stock would have to undergo a huge rally for you to earn any money.  Although some people recommend buying puts for protection, I am adamantly opposed to that idea.

Selling your holdings represents the perfect insurance policy.  There is no cost and there is no risk of loss.  But there is an opportunity cost.  You fail to prosper if the market rallies.  When to sell stocks is a major discussion all my itself.  A reasonable hedge is to sell a portion of your holdings when you deem it to be appropriate.

In general, most investors only know how to buy stocks and if they would learn to sell part of the time, they would do much better.  I’m not suggesting timing the market.  No.  Just taking some profits when prices rise ‘enough.’  And add to holdings when prices decline sufficiently.  But traders are subject to emotions and the majority cannot sell when prices are rising.  That’s a major problem for investors.

Collars are easier to analyze.  In most cases, the cash outlay is minimal.  Thus, ask yourself:

Am I willing to cap my profits if my stock reaches the strike price of the call option?  Or must I earn more than that?

Is the protection (the most I can lose on a decline) acceptable?

Am I willing to guarantee a maximum loss – at an acceptable level – in exchange for the possibility (note: that’s all it is – a possibility) of extra profits?

If ‘Yes,’ the collar is for you.

If ‘NO,’ you and collars are not well-suited for each other.

3.  As far as put options are concerned, do you have any preference on – out of money or – in the money put options to hedge positions? Does it make any difference because of the time decay or any other factor?

a) The purpose of these options is to buy insurance.  It is NOT to earn a profit.  Thus, there is a very big difference in approach.

b) The options should be out of the money.  That’s enough protection.

c) If you want to buy in-the-money put options as insurance, then you should sell stock instead.  There is no need to pay such a high premium for a stock that you are afraid will decline in price.  Insurance is protection against ‘being wrong.’  You do not want to own stock you suspect will decline in price.  And if you do not expect it to decline, there is no reason to buy in the money options.

Bottom line: Insurance is not for everyone.  In my opinion it is far better than depending on proper asset allocation and diversification to protect your assets.  In a very globalized economy, there is a good possibility that all asset classes can move in tandem.  If that happens in a debacle, you can be severely hurt.  I’d rather trust in owning collars (with a guarantee) than depending on out-of-date investing guidelines.

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