Puts Provide Market Insurance
Insurance is purchased for almost every aspect of our lives from health and disability to our homes and cars in order to protect us from a liability or bad event that could be financially inconvenient or even worse. The money that we pay for such insurance—the premium—is usually an obscure amount which only an actuary could understand how the bill is calculated. Yet the insurance bill always seems way too expensive until an unfortunate event occurs in which case it is no longer perceived as a necessary evil that costs us a fortune.
If you think that insurance costs are a little on the high side, think again! In fact, one of the most important and complex life costs that we will ever face is retirement. This is especially true since life expectancies are growing from years past whereby retirement costs were mostly assisted by pension plans that guaranteed fixed payments retirees for life. However, defined benefit plans (pensions) are essentially becoming extinct with only 4% of private sector workers solely relying on one; down from 60% in the early 1980s. As life expectancy continues to increase, it is putting pressure on what has become almost a herculean task for us to save up enough during our working years to cover retirement expenses.
Retirement assets are easily the largest asset many families possess though it is the one asset that is typically not “insured.” Rather, investors look to manage between risky and less risky assets, constantly tweaking the ratio between the two as they progress through life. Another option which may allow investors to take on more of the riskier portion of the equation, namely equities, is to incorporate options, particularly puts into their portfolios.
A put is a right to sell a security at the chosen strike price. For example, if the S&P 500 is trading at 2,700 and an investor purchases the 2,600 strike put, that investor has the right to sell S&P 500 at 2,600 at any point. If the S&P 500 increases to 3,000 over the term of the put the investor will simply not exercise their right. Conversely, if the S&P 500 drops to 2,300, then the investor will exercise their put, selling the S&P 500 @ 2,600 and generating only a ~3.7% loss as compared to an overall market loss of ~14.8%. Now like all insurance, there is a cost to purchase that put, though in the second example it was well worth it. An investor needs to figure out the term of their put (insurance) and analyze pricing of the various puts below the market in deciding the combination of deductible versus premium paid.
Conceptually, there are two ways to approach one’s insurance coverage. One can purchase full coverage but with a lower maximum cap on payments or conversely pick a high deductible product with a larger payout in a truly devastating loss. Essentially, puts can be structured the same way. For investors that want protection from the “black-swan” events that happen ever so often in the market place, a high deductible approach may be the right way to go. For example, an investor may purchase a put 10% to 15% below the market in order to protect the majority of their equity though put at risk of first loss those initial dollars. A popular strategy that incorporates this philosophy is called a collar – where the strategy limits downside loss below a certain level in return for performance to a cap. Conversely, for the investor who wants to protect from first loss though is willing to have some risk if the market strays too far down, they can “buffer” the market. By creating a buffer the investor protects on the initial 10% – 20% of a decline but is then at risk on further drops.
Ultimately, there is no right way to go in regards the perfect strategy to provide a hedge to the market. However, the key takeaway is that puts allow investors to flexibly place insurance on one’s nest egg.