Using Options as Portfolio Insurance

08/17/2011 3:30 pm EST

Focus: OPTIONS

James Bittman

Senior Instructor, Chicago Board Options Exchange

Options aren’t just for speculation and can also act as valuable protection, or "insurance," for the profits and principal in your portfolio or trading account. CBOE options instructor Jim Bittman explains.

My guest today is Jim Bittman, and Jim, I know you look at the options market every which way. A lot of people are looking to protect their portfolios; are options a way to protect your portfolio?

Absolutely Karen, that’s why options were invented. A lot of people don’t realize that. Too many people think that options are only for speculation. In fact, options are insurance-like instruments.  

Now how much does it cost to protect a portfolio? Well, that varies by the level of volatility in the market.

In May 2011, when the CBOE Volatility Index (VIX) was at a multi-year low near 15%, a typical investor with a diversified portfolio could buy an index option and protect that portfolio for up to seven months for less than 4% of the total portfolio value.

See video: VIX Trading 101

If you were looking for a large decline in the market, say 12%-15%, you could only spend 4% of your portfolio and be assured of not having a loss greater than about 4%.

How about right now; is it expensive to protect your portfolio?

Yes, the cost of portfolio protection has gone up. It now costs over 5% to protect a portfolio, the typical diversified portfolio, for six to seven months.

But it’s still worth it, don’t you think?

That depends on your market view. If you really believe that there is a significant probability of a 10%-15% further market correction, then it is certainly worth paying 5% today to reduce your risk. It leaves all the upside in tact, and it reduces the downside. 

If you believe that this market move has been overdone and that we’re due for a recovery, what do you suggest people to do?

Now’s the time to be fully invested. 

And stay from the options?

Well, if you want upside leverage, then you can use options to buy the upside. If you have a significant cash portion—because maybe you’ve been stopped out or maybe you saw the decline coming and you moved to cash—then those people could be wrong getting fully invested now. 

Now might be the time to buy one call option for each 100 shares that you would buy if the market goes up. That’s one very good way to use options in today’s market. 

Buy what they call the “90/10 strategy,” where you put 10% of your money into call options and leave 90% of your money in cash. 

That way if the market does rebound, the calls will enable you to participate on the upside. If you’re wrong and the market collapses, then your risk is limited to the amount you paid for the call options.

See video: How to Hedge with Options

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