Portfolio Insurance using Index Puts Explained

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What Is Portfolio Insurance?

When the stock market goes down, portfolio insurance pays off.

Portfolio insurance isn’t a policy, it’s an investment strategy. When you use portfolio insurance, you bet on the stock market going up, while hedging against the risk that your investments will tank instead. In theory, by balancing stocks and options on stocks, you can achieve a risk-free portfolio.

Principles

An index put option is one way to establish portfolio insurance. Suppose you hold a basket of stocks you believe is going to go up, but market trends have you second-guessing your strategy. To protect yourself, you pay another investor for put options. These give you the right — but not the obligation — to sell some of your shares once a particular stock index reaches a given level. The options give you an out that will minimize your losses by selling the stocks at a profit.

History

Portfolio insurance was born in the mid-1970s. Many investors had dropped out of the market, but Hayne Leland figured they’d return if they could hedge against risk. He began offering a portfolio insurance service. Leland learned that market volatility made protecting portfolios harder: A strategy hedging against a 15 percent market swing didn’t help if the swings were steeper. However, Leland’s firm eventually developed strategies to cope with highly volatile markets.

Benefits

Even the best investor can get blindsided by unexpected developments — wars, shortages, pandemics — that plunge the market or particular market sectors into free fall. With enough put options at the right price, the profit from selling them can offset most or all of the losses from a bad market swing. If the market continues going strong and the underlying stocks continue gaining in value, you can just let the unneeded put options expire.

Drawbacks

Nothing is completely cost-free, including portfolio insurance. It costs money to buy put options, and the more options you buy, the more expensive it is. If you exercise the options the protection pays off, but fees still eat into your profits. If the market stays flat — if your portfolio doesn’t fluctuate much in value during the option period — then the money you spent on the options won’t produce any gains to offset the cost. But you will have bought peace of mind.

Buying Index Puts

The index long put is the simplest strategy to use in index options trading and the implementation involves the purchase of an index put option.

Index Long Put Construction
Buy 1 ATM Index Put

The options trader employing the index long put strategy believes that the underlying index level will fall significantly below the put strike price within a certain period of time.

Unlimited Profit Potential

Since they can be no limit as to how low the index level can be at the option’s expiration date, there is no limit to the maximum profit possible when implementing the index long put strategy.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Index Settlement Value

Limited Risk

Risk for the index long put strategy is capped and is equal to the price paid for the index put option no matter how high the index is trading on expiration date.

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Breakeven Point(s)

The underlier price at which break-even is achieved for the index long put position can be calculated using the following formula.

  • Breakeven Point = Index Put Strike Price – Premium Paid

Example

XYZ Index is a broad based index representative of the entire stock market and its value in June is 400. Believing that the broader market will retreat in the near future, an options trader purchases an six-month XYZ index put with a strike price of $400 expiring in December for a quoted price of $4.00 per contract. With a contract multiplier of $100, the cost of the index put option comes to $400.

Suppose XYZ Index dropped to 380 in December and the trader’s DEC 400 XYZ index put expires in-the-money. At settlement value of 380, the DEC 400 XYZ index put option will have an intrinsic value of $20 and exercising this option will give the trader a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the cost of the option itself, which is $400, the trader’s net profit comes to $1600.

Suppose XYZ Index went up to 420 in December and the trader’s DEC 400 XYZ index put expires out-of-the-money. At settlement value of 420, the DEC 400 XYZ index put option will expire worthless with zero intrinsic value. The trader’s net loss is equal to the amount paid for the index put option which is $400.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Out-of-the-money Index Puts

Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.

In-the-money Index Puts

In-the-money puts are more expensive than out-of-the-money puts but less amount is paid for the option’s time value.

Portfolio Insurance

Index puts can also be used to protect a portfolio against a declining market without the need to liquidate any stock while at the same time enable the portfolio to participate and benefit from a rising market.

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Portfolio Insurance

What is Portfolio Insurance?

Portfolio insurance is the strategy of hedging a portfolio of stocks against market risk by short-selling stock index futures. This technique, developed by Mark Rubinstein and Hayne Leland in 1976, aims to limit the losses a portfolio might experience as stocks decline in price without that portfolio’s manager having to sell off those stocks. Alternatively, portfolio insurance can also refer to brokerage insurance, such as that available from the Securities Investor Protection Corporation (SIPC).

Key Takeaways

  • Portfolio insurance is a hedging strategy used to limit portfolio losses when stocks decline in value without having to sell off stock.
  • In these cases, risk is often limited by the short-selling of stock index futures.
  • Portfolio insurance can also refer to brokerage insurance.

Understanding Portfolio Insurance

Portfolio insurance is a hedging technique frequently used by institutional investors when the market direction is uncertain or volatile. Short selling index futures can offset any downturns, but it also hinders any gains. This hedging technique is a favorite of institutional investors when market conditions are uncertain or abnormally volatile.

This investment strategy uses financial instruments, such as equities, debts, and derivatives, combined in such a way that protects against downside risk. It is a dynamic hedging strategy that emphasizes buying and selling securities periodically to maintain a limit of the portfolio value. The workings of this portfolio insurance strategy is driven by buying index put options. It can also be done by using listed index options. Hayne Leland and Mark Rubinstein invented the technique in 1976 and is often associated with the October 19, 1987, stock market crash.

Portfolio insurance is also an insurance product available from the SIPC that provides brokerage customers up to $500,000 coverage for cash and securities held by a firm.

The SIPC was created as a non-profit membership corporation under the Securities Investor Protection Act. The SIPC oversees the liquidation of member broker-dealers that close when market conditions render a broker-dealer bankrupt or put them in serious financial trouble, and customer assets are missing. In a liquidation under the Securities Investor Protection Act, SIPC and a court-appointed trustee work to return customers’ securities and cash as quickly as possible. Within limits, SIPC expedites the return of missing customer property by protecting each customer up to $500,000 for securities and cash (including a $250,000 limit for cash only). Unlike the Federal Deposit Insurance Corporation (FDIC), the SIPC was not chartered by Congress to combat fraud. Although created under federal law, it is also not an agency or establishment of the United States government. It has no authority to investigate or regulate its member broker-dealers. The SIPC is not the securities world equivalent of the FDIC.

Benefits of Portfolio Insurance

Unexpected developments – wars, shortages, pandemics – can take even the most conscientious investors by surprise and plunge the entire market or particular sectors into free fall. Whether through SIPC insurance or engaging in a market hedging strategy, most or all of the losses from a bad market swing can be avoided. If an investor is hedging the market, and it continues going strong with underlying stocks continue gaining in value, an investor can just let the unneeded put options expire.

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