Would you drive a car without insurance? If you could protect your portfolio from a heavy crash or even a small dent in the same way that you insure your car, would you pay the insurance premium in return for the peace of mind?
Over the course of the last year many funds have incurred significant losses in their holdings. Most recently, Tiger fund ($17 billion AUM) reported a year-to-date loss of 54.7%. If you have a portfolio of stocks which are in the FTSE 100 and are concerned that it might decline in value, then you can buy a put option on the Index as a hedge to limit the losses from your existing positions.
This trade should be viewed as an insurance policy as we do not want to see the value of our portfolios erode but are happy to pay a small premium relative to our holding to protect against the downwards pressure, which we have abundantly witnessed over the past year.
Adopting this strategy does not cap your potential profits. The profits from the strategy are determined by the growth potential of the underlying assets you hold. However, a portion of the profits is reduced by the premium paid for the downside protection the put option.
This strategy will create a limit for potential losses as any losses in the index below the strike of the put option will be compensated by profits in the option.
Buy a Protective Put on the FTSE 100 Index – Example trade
In this example the Investor holds several stocks listed in the FTSE 100 Index with a current value of £70,000 and wishes to use the FTSE Index as a proxy for their positions.
Buy Jun2023 6900 Put for 195p, or 2.8% of 6900 (notional value £69,000)
The investor is hoping to achieve long term capital appreciation and dividend income by holding these stocks. However, they believe that there could be a dip between now and June 2023. There could be several reasons why they want to keep the stocks e.g., they may pay a good dividend, they do not want to crystallise a capital gain or even that they just feel like they are a good long-term hold. Therefore, instead of selling the stocks they can buy a Jun23 6900 put. The index is currently trading at 7300. This put is therefore 5.5% below the current market value. (To place this in perspective, we saw a 5.5% decline only last month in the week between the 6th and 13th of October 2022.)
The Index continues to rise and ends at 7700 in Jun23 (5.5% above the current market value)).
This would be the ideal scenario as it would indicate an increase in the underlying stock holding (~5% increase on £70k = £3,500). The total loss would be the cost of the ‘insurance policy’ (£1,950 per 1 lot), leaving a net profit of £1,550.
The Index declines by 20%, ending at 5,840 in Jun23. Should the index approach its covid lows, the protective put will be in the money by 1060 points, making it worth £10,600. Yielding a net profit of £8,650 (£10,600 – £1950), which is a risk to reward ratio of around 1:5. In this example, the investor’s underlying portfolio has declined by ~£14,000, but this is offset by the put option’s gain of £8,650, reducing the loss to a net £5,350 (£14,000+1950-10,600=5,350).
Index remains at 7300. Like the first scenario, the total loss would be the cost of the ‘insurance policy’ (£1950 per 1 lot). However, in this case the portfolio may not have increased in value. This scenario can be likened to taking out a car Insurance policy for the year without having the misfortune of needing to make a claim.