Buying put options as an insurance policy on your portfolio is like having homeowners insurance to protect your house against a fire.

It’s not cheap to insure large portfolios for long periods of time. But with today’s market conditions, the cost to buy puts as insurance can be small compared to the losses you could suffer.

The U.S. stock market has gone up extraordinarily fast in a short period of time… and we could experience a major pullback, therefore investors may want to consider taking out some portfolio insurance.

Here is an example on how to use put options as an insurance policy for a portfolio:

An investor with a well diversified portfolio consisting of U.S. stocks that is closely correlated to the S&P 500 has a total value of $100,000. The investor is concerned about a possible market pullback… therefore the investor decides to insure his portfolio by purchasing just out-of-the-money SPY put options expiring in July. The current level of the SPY is 92 and the July 90 puts cost $3.40 each.

The SPY options have a contract multiplier of $100, so the number of contracts needed to completely protect his portfolio is: $100,000/ (92 x $100) = 10.87 or 11 contracts. The total cost of the options is: 11 x $3.4 x $100 = $3,740.

If the market pulls back, the value of the investor’s put options will rise and offset the losses taken by his portfolio.

If the investor’s expectation of a falling market is incorrect, his portfolio can continue to profit in the rising market.

Worst case scenario–If the market remains flat, he will lose $3,740, which is equal to the premium paid for the put options insurance.

Nowadays, you may want to consider put options as an insurance policy for your portfolio to avoid large losses. The U.S. equity markets look overbought right now and this strategy could protect you.

Best Wishes,

Ted Peroulakis