Crash Insurance: Protecting a Stock Portfolio like a Home

By Michal J Lodziana, Opinion Editor

No sane individual would purchase an expensive home and not insure it. It simply doesn’t make financial sense. Just ask the thousands of homeowners whose property was recently destroyed in California wildfires. Fox News reports that in just one of the many recent wildfires, more than 100 homes were burnt to a crisp! Now imagine if some of these homeowners didn’t have insurance… Yikes!

We can all agree that having home insurance is a smart choice, especially considering the fact that Bloomberg reports that more than half of the median American’s net worth is tied up in home equity.

Can you imagine losing more than half of your net worth overnight, due to a fire? Although home insurance is great, I can’t help but ask: what about stock portfolio insurance?

The simple fact is that like a property, a stock portfolio’s value can collapse in the case of a stock market crash. Because mega stock crashes like those in 2000 and 2008 are becoming more commonplace, and the S&P 500 has been flirting with all-time highs once again, it might not be a bad idea to look into picking up some insurance.

That’s where “put” options come in. Rather than “shorting” a particular stock and exposing investors to potentially unlimited downside risk, put options allow them to “short” the market whilst limiting their potential losses. This is because investors can only lose the amount they initially paid for their “policy”.

Like a home insurance policy, an investor can purchase a put option contract, which entitles them to sell 100 shares of a particular company/index, for a set strike price, which is defined as the price the investor is entitled to sell each one of the 100 shares they are in control of.

For example, let’s say that I am an investor with a $25,000 portfolio of stocks. I’m really worried about a 30 percent stock market crash ($7,500 loss), and I want to preserve gains that I’ve made over the past few years. I would look to purchase an SPY (ETF that tracks the S&P 500 index) put option.

More specifically, I would be interested in a January 16, 2018 SPY put at the $200 strike price, which is currently trading for around $1,400 per contract (Keep in mind prices can fluctuate rapidly). This way, if the market crashes about 30 percent, I stand to lose significantly less than the full $7,500. And if I’m wrong? All I lose is the initial $1,400 premium.

Keep in mind, however, that like is the case with a house, it is better to buy insurance whilst things are still relatively calm. The broad U.S stock market just posted highs several weeks ago, and volatility is not as high as it was in June (Although it increased dramatically this past Friday). Investors would be wise to invest in policies as soon as possible.

If one is interested in purchasing put options, waiting until the market corrects significantly is the equivalent of calling up an insurance agent to set up an insurance policy, at the same moment one’s house catches on fire. It just won’t work out too well, and the individual will end up on the wrong end of a particular trade.

As a fair warning to my readers, put options are not meant for novice investors. You should never invest in something you don’t understand. However, by considering put-options, you can sleep sound at night, knowing that you won’t get wiped out by a market crash.

If you’re not comfortable with using options, you should at least consider taking profits on existing stock positions and holding onto more cash. Cash isn’t a bad thing during a stock market crash, and it will provide the average investor with a great opportunity to buy quality stocks at favorable valuations. Right now, a strong case can be made that the overall market is heavily “overvalued”.

Historically speaking, stocks are at incredible highs. Michael Sincere of Market Watch points out that for the first time since 1999, all three major stock indexes are at record highs.

Negative interest rates are spreading across the globe, while corporate profits continue to remain stagnant. At the very least, investors should be cautious about where they put their money and try to keep their risk profile as low as possible.

Never underestimate the risk of a fire. You should think of a stock portfolio as you think of your home. You wouldn’t want to have a home without insurance. With the risks of a stock market crash escalating, why not have something to protect a portfolio as well?

A version of this article appeared in the Tuesday, September 13th print edition.

Contact Michal at

michal.lodziana@student.shu.edu

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