Fund Investing

Put options provide a safety net.
By Gail Bebee | 03/09/10

If you buy into the idea that historical stock-market data has some predictive value, now would seem to be an opportune time to take steps to protect your equity portfolio from losses.

About the Author
Gail Bebee is an independent personal finance speaker, teacher and the author of No Hype--The Straight Goods on Investing Your Money. She can be reached at gbebee@gailbebee.com; her website is www.gailbebee.com.

Historically, September has been the worst month of the year for stocks. According to a recent issue of the Technical Speculator newsletter, there is a 50-year track record of 73% of Septembers finishing negative for equity markets. October has its own dismal reputation as a volatile month for stocks, owing to the devastating stock-market crashes of 1929 and 1987.

Other than selling your holdings, probably the simplest strategy to insure your portfolio against losses is the protective put. A put is an options contract that gives you the right, but not the obligation, to sell a stock at a fixed price within a certain time period.

During the term of the contract, a put option gains in value if the stock price falls. By buying the appropriate number of puts priced at or near your original stock purchase price, you establish a floor on the value of your investment.

Puts are available on individual stocks, generally those of larger, well established companies. But you can buy a put without having to bet against a specific company, since they are also available on some of the larger exchange-traded funds.

By buying a put for an ETF based on a widely recognized stock-market index, you can protect your equity portfolio with just one purchase. For example, you can buy puts on iShares S&P/TSX 60 Index XIU, which is by far the largest ETF in Canada.

XIU holds 60 of the largest, most liquid Canadian companies trading on the Toronto Stock Exchange and is a decent proxy for the Canadian portion of the average investor's equity portfolio. Looking beyond Canada, you can also buy put options based on ETFs that invest in other established broad general indices such as the S&P 500 Index in the United States.

Let's look at an example of how a protective put for iShares S&P/TSX 60 Index would work, assuming that you wanted to insure a $50,000 holding until mid-October.

We begin by consulting the website for the Montreal Options Exchange, the market for options for Canadian-listed securities. An October put will buy protection against a stock-market dip until Oct. 15, which is the third Friday in October.

On Sept. 1, a put which confers the right to sell a share of XIU for $17.50 (this is referred to as the strike price) until Oct. 15 (the settlement date) was being offered at 40 cents.

Puts are sold in contracts of 100 shares. Therefore, buying 29 contracts of this put ensures that your portfolio would be worth about $50,750 ($17.50 multiplied by 2,900) on Oct. 15; the precise value depends on how tightly your actual portfolio mirrors the stocks inside XIU. The cost or premium for this portfolio protection would be $1,160 (2,900 times $0.40) plus brokerage commission.

When the put-option expiration date nears, you have two choices. First, if the stock market is higher and XIU trades above $17.50, you let the put expire worthless. While you've paid the option premium and haven't collected anything, you can at least feel satisfied that the premium you paid has allowed you to sleep at night without worrying about your investments.

Secondly, if XIU is priced below $17.50 a share, you cancel or close out the put with an offsetting options contract. If XIU is trading at $16, you would sell (write) 29 put contracts at the exact same terms, XIU $17.50 Oct. 15, to another buyer before the market closes. These puts will be worth about $1.50 each ($17.50 minus $16) and the money you receive by selling these contracts, $4,350 (2,900 times $1.50), should help offset the drop in the value of your portfolio. On Oct. 15, both sets of options are exercised and your two positions cancel each other out.

Put contracts usually expire in a year or less. Contracts called Long-Term Equity Anticipation Securities, or LEAPS, are available for terms of a year or longer. This week, XIU puts at $18 (about 40 cents higher than the current price of the ETF) with a March 2013 expiration date, were being offered in the $3.30 range. The higher premium reflects the longer opportunity for stock-price depreciation (and put-price appreciation). If you plan to buy puts on an ongoing basis, LEAPS will enable you to save on commissions, but bear in mind that you are paying for the time value of money, and LEAPS pricing can be volatile.

Insuring your portfolio via puts can be a significant drag on your investment returns. Consequently, investors should undertake a cost-benefit analysis before embarking on a protective put strategy. In some instances, the cost may not be worth the benefit. You might decide, for instance, that a diversified portfolio of high-quality stocks or ETFs sufficiently reduces your risk of capital losses.

If you do decide to use protective puts but lack expertise, you'll want a financial advisor who understands options (many don't) and who is either licensed to trade options or has access to someone who holds this licence.

Self-directed investors should learn the basics of options trading before making their first options purchase. Excellent online training tools are found at the web sites of some discount brokers and the various options exchanges. The Chicago Board of Options Exchange (CBOE) the world's largest options exchange, offers a wealth of online educational resources on its website.

In times of economic uncertainty, protecting your equity investments by buying puts may be worth the cost just for the peace of mind it confers. As with any investing, doing your homework before you buy could be your best investment.

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