Buying Put Options – More Protection Than You Realize
The Nasdaq-100 Index is off to a great start in 2020 following a fantastic finish in 2019 when it gained more than 38 percent if you include dividends.
It is easy for investors to get, well, uneasy following such a great year as they think a pullback is inevitable. But just because the Nasdaq-100 climbs doesn’t mean it has to fall back – stocks tend to appreciate as companies continue to innovate and grow and generate profits. For example, the Nasdaq-100 gained more than 37 percent in 2013 and if you had sold your holdings at the beginning of the following January just because you expected a pullback you would have missed out on the more-than 20 percent gain in 2014.
For investors who want downside protection for their existing Nasdaq-100 portfolio but also want to remain invested in order to participate in any future appreciation, there are protective put options.
A put option on the Nasdaq-100 gives the owner of the put option the right, but not the obligation, to sell the portfolio underlying the option at a predetermined price, called the strike price, when the option expires. In exchange for this right the buyer of the put option will pay cash, called the option premium, to the seller of the put option. In this way buying a put option to protect an existing portfolio is just like buying insurance; it protects against a decline in value.
But if this insurance allows for an investor to remain invested rather than sell some or all of their holdings then buying a put option does something very special – it also protects against an increase in value that an investor would miss if they felt compelled to sell some or all of their holdings.
This is because by remaining long the Nasdaq-100 portfolio the investor participates in all the gain to the upside after paying for the put option. While put options can be expensive, meaning an investor can’t afford to own protection constantly, from time to time it can make sense to own put protection.
Let’s look at some payoff profiles for protective put options on the Nasdaq-100 after it opened 70 points higher at approximately 8800 on Thursday, January 2.
Just after the open of trading on Thursday an investor who was long the Nasdaq-100 and wanted to remain both fully invested yet get some protection could have bought the 8700 strike put option expiring on February 21 for 151.00. That 151.00 represents 1.7 percent of the value of the portfolio and protects against any drop below 8549 (the 8700 strike price minus the 151.00 cost of the option) which would be a loss of 2.9 percent. That would be the maximum loss for any portfolio protected by this put option. You can see this below.
But if owning this protection means our investor is able to sensibly remain fully invested then this put also offers protection to the upside. This is important to anyone investing for the long-term.
It shouldn’t surprise us that owning a protective put option can protect an investor to the upside; we’ve already looked at put option strategies which are bullish. Selling an NDX put option to buy the Nasdaq-100 at a discount is a great investment strategy which takes advantage of the fact that put options are expensive. It is also a mildly bullish to sideways strategy.
Finally, a risk reversal is a strategy which uses put options and is an outright bullish strategy. We’ll discuss a risk reversal in an upcoming post.
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Performance of an index is not illustrative of any particular investment. Index returns quoted represent past performance which is no guarantee of future results.
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