“Now is the ideal time to buy insurance.”
You’ve probably heard that before. Especially if you’ve ever met a life insurance salesperson.
But with many major stock market averages near all-time highs, now really is an ideal time to consider insuring your investments.
Put options protect against a decline. And they’re affordable now. If the market crashes, they’ll become unaffordable.
This is one reason put options act as insurance. They rise in value when prices fall.
Weighing the Benefits and Risks of Puts
A put option gives buyers the right to sell a stock or exchange-traded fund (ETF) before the option expires at a predetermined price (also known as the strike price).
Puts on the SPDR S&P 500 ETF (NYSE: SPY) can protect a diversified portfolio.
With the SPY trading near $396, investors may be worried about a 20% decline. That would push the price down to about $316.
A put expiring in October offers protection against a loss like that until October 15.
The cost of the put is the insurance premium. If the market suffers a big loss, then the insurance pays off. But if it doesn’t, then the option loses value.
A SPY put option with an exercise price of $380 costs about $20. Options contracts cover 100 shares of SPY. That means this contract costs $2,000.
A put option rises in value when prices fall. In this example, the $380 put gives you the right to sell 100 shares at $380.
Now, if the SPY falls to $316, you could buy shares for $316 and then immediately sell them at $380. That’s a guaranteed profit of $64 per share, or $6,400 per option contract.
But with options, you won’t have to do all that. Options markets allow you to take the profit without having to buy the shares. You simply sell the put to close the trade.
However, there are risks. This option benefits investors in a crash but reduces profits if the bull market continues.
The table below summarizes the impact of that trade on a $10,000 account:
The bottom line is that insurance protects wealth in bear markets.
But holding portfolio insurance is expensive. And the damage it does to wealth growth in a bull market is significant.
Even when market insurance is available, it’s a good idea to consider other ways to protect your investments in a significant decline.
Rather than using insurance, it might be better to follow the market more closely and take steps to protect your account only when stocks are falling.
For example, a short-term strategy like One Trade could be the best defense in a bear market and the best offense in a bull market.
In fact, this strategy beat the market more than eight times over with a 132% annual return in 2020.
You can learn more about it here.
Michael Carr, CMT, CFTe
Editor, One Trade