Options frequently get a bad rap as being risky and that the leverage they offer can get investors into trouble. But it is worth remembering that leverage can be a double edged sword in that while it can both lead to outsized returns and losses it can reduce risk. With the S&P 500 Index’s having now fallen back below its 200 day moving average and a recent spate of weakening economic data points the stock market is looking on shaky ground. So this is a good time to revisit how using options is a good way to provide some protection to your portfolio.
The simplest strategy is the purchase of put options to limit the loss incurred if the price of the underlying asset declines. This is known as a married put. Like most insurance, it comes with a cost that will have a drag on returns. But thanks to the leverage of options, a small amount of money can buy you a lot of coverage.
The cost, like insurance, will, of course, depend on several factors. For example, the term or amount of time, because the longer the policy, the lower the annualized cost. Also, the condition of the asset being insured must factor in. An analogy would be a house sitting on a fault line or a pack-a-day smoker, both of which will have higher insurance premiums. Finally, you must decide what size deductible or out-of-pocket loss you are to willing to accept.
An Apple Today
Let’s use Apple (AAPL) as an example as it has been a tremendous performer, up some 20% for the YTD and over 150% for the past 52-weeks. It has a relatively high beta of 1.80. That means if the market at large or, say, the S&P 500 rises or falls 1%, shares of Apple should experience a 1.8% change in price. So, as a stock that is expected to move or produce returns, profits or losses, nearly twice that of the broad market, one can consider it fairly risky, and therefore, its insurance will be relatively expensive.
With Apple currently trading around $250 a share, you can buy the April puts with a January 2011 expiration for $20 per contract. Assuming you owned 1,000 shares of Apple, a reasonable amount of coverage might involve buying 10 of these puts, which would cost $20,000, or nearly 8% of your investment. Consider that your deductable.
What do you get for that 20 grand? First, understand that currently the delta of these puts is around 0.35, meaning that for each $1 move in the price of Apple shares, you can expect the value of the puts to move 35 cents. So, at the moment, your deductible on any initial decline you only have 350 shares, or about 1/3, of your position. So, depending on the timing, a 10%, or $27 decline in Apple down to $243, would have a loss of about $13,000 as the puts will not have increased as much as the stock declined.
But since delta moves on a slope, meaning it increases as the options move further into the money, your full coverage—or where the value of the 10 put options will increase on a one-to-one basis for each dollar decline in Apple stock—will begin at around $235 per share or around a 12.5% delcine.
A Pre-Emptive Strike Price
Now how does that compare to simply selling off a portion of the shares to reduce risk and margin requirements. Selling 300 shares of Apple at $235 will result in the $10,500 draw down from current levels, slightly less than the approximately $15,000 drawdown that would be incurred with the married put position but it still leaves 700 shares, or some $165,000, exposed to further losses.
The leverage provided by the put option prevents incurring any further losses over the next eight-month period. Also, you still own that full 1,000 shares, meaning you retain the same upside potential should Apple resume its rally.
For a stock that has gained more than 160% over the past 52 weeks, this seems a reasonable price to protect this investment. Let’s face it, like that house sitting on a peninsula in the middle of hurricane alley, it takes only one small squall—such as a problem with the iPhone batteries or a backlash against the contracts that offer a limited choice of carriers yet long-term commitment—to knock down what underpins the high growth projections.
On the flip side, if it all lives up to its promises and the iPhone and other Apple products have blowout holiday sales, the stock could easily rise hit the $320-$350 price targets held by many analyst by January, a 25% gain.
Now no one wants to give away nearly half of that profit—remember the purchase of these puts moves your effective cost basis or purchase price up to $290 a share—but it’s a lot easier to be magnanimous knowing you stand to gain an additional 25% or more while your losses are limited to just 12% from current levels. The lesson: That while leverage has its downside, by applying it in a pre-emptive fashion, you will be well positioned to reap the advantages of its upside.