In a recent Smart Profits Daily article, I explained how it’s possible to insure your stock market holdings against a crash. This strategy used put options on the SPDR S&P 500 ETF (NYSE: SPY).
Put options protect against a decline. They’re affordable now. But when the market crashes, they’ll become high-priced.
This is one reason put options act as insurance. They rise in value when prices fall. But puts are different from standard insurance.
You can’t insure your car after a crash. You can, however, buy SPY put options when stocks crash. They just cost more.
Often, they become so expensive that they aren’t effective insurance. This means that timing is important when buying puts.
The time to buy is before the crisis hits. And puts offer a way to insure against many risks, including inflation.
Inflation Means Rising Interest Rates
In simple terms, inflation means that the prices of goods and services rise. This has unpredictable impacts on stock prices.
One of the few certainties associated with inflation is the fact that interest rates will rise. That’s because interest rates consist of three components.
One part is the return on investment. This is the investor’s income for lending money. This component doesn’t change very much in the long run.
A second part is a default risk premium. This is the investor’s protection against the loss of principal. Treasury bonds can’t default, so this component equals zero on those securities.
Third is the inflation risk premium. This component varies with the outlook for inflation.
Right now, it’s low. If inflation rises, then it will increase sharply. This is the factor that almost guarantees that interest rates will rise.
And as rates rise, bond prices fall. This relationship exists because once bonds are issued, they trade in the secondary market.
This provides liquidity for investors who might not want to hold the bonds to maturity. But it means that old bonds must be priced competitively against newly issued bonds.
If new bonds are being issued at higher rates, then older bonds must drop in price so that investors can pay less and receive an amount of income equivalent to the new bonds.
By one estimate, Treasury bonds will decline 18.5% if interest rates rise 1%. This fact offers an opportunity to insure against inflation risks.
How to Protect Your Wealth if Inflation Picks Up
When rates rise, put options on the iShares 20+ Year Treasury Bond ETF (Nasdaq: TLT) will increase in value.
If rates rise 2% on inflation fears, then TLT should fall from about $135 to about $108. A put expiring in December offers protection against a loss like that until December 17.
The cost of the put is the insurance premium. If the market suffers a big loss, then the insurance pays off. If it doesn’t, then the option loses value.
A TLT put option with an exercise price of $130 costs about $6. Options contracts cover 100 shares of TLT. That means this contract costs $600.
A put option rises in value when prices fall. In this example, the $130 put gives you the right to sell 100 shares at $130.
If TLT falls to $108, then you could buy shares for $108 and immediately sell them at $130. That’s a guaranteed profit of $22 per share, or $2,200 per option contract.
But with options, you won’t have to do all that. Options markets allow you to take profits without having to buy the shares. You simply sell the put to close the trade.
But there are risks. This option benefits investors in a crash but loses money if interest rates fall. You could lose up to $600, the amount you pay for the put.
The bottom line is that insurance can protect your wealth if inflation picks up.
While holding insurance carries risks, inflation is also a threat to your wealth. If you believe inflation is a serious risk, then now is the time to insure against it.
Michael Carr, CMT, CFTe
Editor, One Trade