Buying Puts for Downside Protection

The Nasdaq-100 Index is up more than 37 percent year-to-date and has recently made a series of all-time highs.  That would be a great year for any index but the Nasdaq-100 is set to outperform all the major domestic equity indexes this year (through the close of trading on December 20).

So investors with a portfolio which mimics the Nasdaq-100 might be wondering how they can protect some of those gains, particularly through any selling from profit taking that might occur just after the beginning of the New Year. 

At the close of trading on Friday, December 20, the Nasdaq-100 index was at 8678.49.  We know that buying an NDX put option would provide insurance for our Nasdaq-100 portfolio.  Buying this put in conjunction with owning the Nasdaq-100 portfolio will limit downside loss while, and this is the advantage of buying a put as insurance, allowing an investor to remain long the portfolio to take advantage of any additional appreciation. 

The 8600 strike put option expiring on Friday, February 21, could have been purchased for 161.00 on Friday’s close.  The option costs 1.85 percent of the value of our portfolio.  That’s pretty expensive since it only provides 59 days of protection but it might also provide peace of mind.  We’ll discuss this more in a bit. 

Since it is an 8600 strike put the protection kicks in at that level, 8600.  The 78.49 between Friday’s close and the strike price is similar to the deductible you might have with your homeowners insurance. 

The put option buyer also has to take the cost of the option into account so this put option will be profitable for the buyer at option expiration if the Nasdaq-100 is below 8439.00 (the 8600.00 strike price minus the 161.00 option premium). That would require a fall of 2.76 percent during that period as you can see. 

Each investor will have to decide for themselves if they should execute this trade.  However, put purchases for protection have to be tactical.  No investor can afford to constantly own insurance on their Nasdaq-100 portfolio in the form of puts – the options are just too expensive and will consume most of an investor’s gains in a normal year.  For example, the 8675 strike put option expiring in December 2020 closed on Friday at 575.00.  While that would provide nearly complete protection for a Nasdaq-100 portfolio until December 21, 2020 that coverage would cost 6.63 percent of the value of the Nasdaq-100.  That’s nearly all of what the Nasdaq-100 index returns in many years (average return ignoring dividends since 2000 is 6.71 percent).

Of course our investor could choose a lower strike price and spend less money for the insurance while increasing the amount of the deductible.  For example, in the same February expiration the 8250 strike put could have been purchased for just 84.00. 

But the real beauty of NDX options is the range of strategies available.  An investor buying the 8600 put option for protection could eliminate any cost by simultaneously selling the 8750 covered call at 169.00.  By selling the covered call and buying the protective put our investor would actually collect a net of 8.00.  He has now given up any appreciation above the 8750 strike price of the covered call but also gets the protection we discussed.  This type of trade, long a protective put and short a covered call to reduce the cost, is called a “collar” and we’ll discuss it more in later posts.

There are other ways to get downside protection at lower cost while not sacrificing upside appreciation.  We’ll also discuss those in later posts.

Nasdaq publishes articles about important aspects of the NDX option market each Monday and Thursday.  Check back here for our latest 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.