Options strategy: Get insurance for your portfolio!

A couple, who had invested a major chunk of their savings into presumably strong and safe blue chip stocks, had to rework their retirement plans as the stock markets were down for a long period.

Similarly, plans of parents—who had invested 60% of their savings in stocks portfolio for higher education of their 16-year-old child—had gone haywire because they had invested their savings in the market for too long—instead of taking it out at least three years before they needed it.

It’s terrible to hear these stories because these situations could have been avoided. What lesson can we draw from the past two to three years’ market situations to help shield our portfolios from losses in the future? While almost nobody could have predicted the collapse of so many American institutions, from Lehman to AIG, there is at least one step financial planners can take to protect their clients’ portfolios against future unknowns when the stakes are high. Here comes the use of options strategy for protecting the portfolios.

Options are tools, not weapons

Options have typically been given the polite brush aside. The argument goes, “Most investors don’t need to use options to succeed over a lifetime.” This is true. “And most investors will lose money on options.” This is not true, if you use the options strategy in the right way

For those unfamiliar, options are simply the right to buy or sell a stock at a set price by a specific date. Options were introduced to people in 1973 by the Chicago Board Options Exchange. Options enjoyed increasing trading volume annually for years as people learnt about their value. In India, options are available on most major stocks and NSE (National Stock Exchange) based indices. Nifty Options are the most liquid and highly traded.

I was skeptical of options for several years, too, until I started to learn more about them from various sources. Options helped me to obtain better buy and sell prices, to bet against some positions or hedge others, and to insure against possible declines.

Buying put options for insurance, especially when you have a lot riding on equity positions, can be as smart as having insurance to protect your house against fire. Insurance is not a cheap product but the real value of it is only seen when something unforeseen happens, similarly put option might seem costly but its value will be seen when there is sudden fall or unforeseen event in the market.

How it works?

A put option gives its holder the right to sell a stock / index at a set price by a certain date. Buying a put option—when you also own the stock / index / mutual fund—is basically buying insurance for your stock or hedging against a possible decline.

For instance, if you own 100 units of Nifty , currently trading around 4,900, you could buy two put option contracts (each contract represents 50 units of Nifty) to insure your entire position against further decline.

Today, it would cost you about Rs. 322 per unit to insure a 5000 sell price (strike price) on the Nifty all the way until end-December 2012. So, even if Nifty fell to 2000 during the next seven months, the put option owner would be able to sell out at 5000—for a net sell price of 4678 after accounting for the cost of the puts.

If Nifty falls less than this, and you still believe in its long-term potential, you can sell the puts for a profit and continue to own the Nifty.

On the other hand, if Nifty is 6000 per unit five months from now, your 5000 insurance policy won’t have much value anymore. Still, you are protected on the downside for the past five months, and you’ve profited with the stock as it increased.

There are also secondary benefits. The knowledge that your largest holding is insured may make you comfortable enough to nibble on newly beaten-down opportunities you see, or to keep holding the other, smaller positions you already own. At the very least, with your key positions insured, you won’t run for the hills and sell out at the very worst times. And when the markets recover, you’ll participate.

When to use puts

It’s not cheap to insure large positions for long periods of time, especially in today’s environment. But in these times, that up-front cost can be dwarfed by losses you might then avoid. Generally, you should consider put options as insurance for positions that are large or vital in your portfolio—or the ones which face more risk now than you originally presumed.

Also, if you’re preparing to sell a position in the next one or two years, puts are a handy way to insure yourself a minimum sell price by your chosen sell date. You pay for the privilege but from there it’s all upside—with no worries about downside.

Use options to take advantage of the knowledge of a stock

I use options to leverage my existing knowledge of a stock’s valuation and business model. Many lucrative option strategies exist for stock-based investors—strategies that complement your stock portfolio, rather than compromise it.

I’m not an options speculator or trader. I’m a stock-based investor who understands the power of options when used in conjunction with stock knowledge—and when used for risk management.

If I have an entire MF portfolio how can I use this strategy?

This strategy can be worked with any equity position. Most of the MFs’ (mutual funds) track the Nifty very well. There could be some variation but generally the beta would be very close to 1. The strategy should be employed very sparingly when there is high amount of uncertainty or goal is very close by.

When options can turn destructive?

If options are used by investors as a leveraging tool and not a risk management tool, they could destroy capital. Suppose an investor wants to make super normal profit. He buys a Nifty Call option at 5000 for Rs. 100. This means he invests Rs. 5,000. If the Nifty moves to 5200, the option would be worth Rs. 300 or Rs. 15,000. This means the investor has tripled his money in just a couple of trading sessions. But if the Nifty declines to 4900, he would lose his entire capital of Rs. 5,000.

Now, if an investor were to take directional call or trading calls using options it would amplify his return multiple times. This would happen because the instrument has a inherit leverage in it. In simple terms with just Rs. 5,000 the investor is taking a bet on securities worth Rs. 2.5 lakh. A small movement on the security could destroy the entire capital.

Therefore, it is advisable to use options very carefully and with a deep understanding of the reason behind the entire transaction. For financial planners, it could be a great tool to tide over turbulence in markets when things are uncertain.

The author is the chief manager–financial planning & wealth management, State Bank of India.