Most people (at least the responsible ones) can't imagine driving a car without insurance covering it. The same goes for home owners and a lot of renters. Insurance is a mandatory cost for these expensive pieces of property. Jewelry is insured. Cell phones can be insured (if the buyer falls for the sales pitch on it). On the other hand, not many investors insure their stock portfolios. Investment accounts are often worth a lot more than the owners' cars and other portable tangible objects, but very few investors even know that they can buy insurance to cover their investments.
Insurance that covers stocks is called a stock option. Stock options come in two flavors, put options ("puts) and call options ("calls"). Calls can be used to leverage a bullish position or act as insurance for a bearish position. For most investors, puts should be the focus. Puts can be used to create a bearish position without risking much money or can act as an insurance policy on stocks and ETFs that investors own. The latter is the point of this post.
When an investor buys a put, he pays a premium (aka fee) to the seller. The seller has written an option contract with the buyer. In exchange, the seller of the put is obligated to buy a fixed number of shares (typically in 100 share lots) of the stock or ETF that is "underlying" the put. The agreed upon buy/sell price is called the strike. The closer the strike is to the current stock/ETF price, the higher the premium will be because more of the stock's value is insured. All options have an expiration date, just like car insurance does. The longer the duration is before the expiration, the greater the premium is because the buyer is purchasing coverage for a longer period.
Unlike home or car insurance, options do not auto-renew. They are bought and sold for a set period of time and then the contract is over. Also, options can be sold before the planned expiration date if the owner decides he does not want or need the insurance any longer. Depending on how the stock moved since the buyer entered into the contract, he could make a profit on the insurance and still own the stocks he was protecting, but he could lose money on both the stock and the option based on how the stock's price has changed and what the option's strike was. Another difference between car/home insurance and investment insurance is that you don't have to own the underlying stock to buy a put on it. (This is called a synthetic short and is better for another post of its own.)
Those are the basic definitions of how put options work, but an example makes it a lot easier to understand. Let's say you own 100 shares of SPY, an S&P 500 ETF and want to limit your losses in a bear market or another "flash crash". Remembering that premiums cost more when the strike is closer to the current trading price, you decide to set the strike close to 5% below the ETF's value at risk (i.e. at 95% of the ETF's price). Consider this the deductible. (If you can't stomach a 5% loss, an S&P 500 ETF is the wrong investment for your risk tolerance.) Based on SPY trading at $187, the $178 strike that expires on September 19 would cost $4.35 per share or $435 total. Once you own the put, you cannot lose more than the difference between the current ETF price and the strike price plus the premium. In this example, the most you could lose would be $187-$178+$4.35 = $13.35, or 7.1% of the value of your shares. Just as with home/car insurance, the premium is in addition to the deductible. The cost of this insurance would be 2.3% of the share value and could never come into play.
Let's take the example a step further. If you have a total account value of $100,000 and the account is built on a mixture of individual stocks and bonds, you could insure the entire portfolio by using multiple SPY puts. The insurance would not be an exact one-to-one match on every one of your stocks, but should act as strong protection (or "hedge") against a steep sell-off, assuming your stock choices are diversified. Using four SPY puts, such as in the example above, $74,800 of the $100,000 would be insured for a cost of $1,740.00 (not including trading fees). Even this much insurance could be more than is needed depending on your bond allocation, but the example still illustrates the point. $1,740 is 1.74% of $100,000 and in most scenarios, the maximum loss for the account would be limited to 7.1% lower for the account and might be less if bond prices moved higher during the stock bear market.
Keep in mind that this insurance was only for a little more than 22 weeks. To repeat this process throughout a full year, you could end up paying 5.44% of your account value in insurance premiums. For some investors, that's not much too give up considering that the account has such limited downside risk and maintains all of its upside potential. For others, taking the bumps and bruises along the way is just part of buy and hold investing and any insurance costs reduce upside potential.
This example is a very simplified use of options as insurance for your investments. Different strikes and expiration dates can be used to affect the amount of insurance and the cost of protecting your account. Some investors like to combine options to reduce the cost of insurance further. The possibilities can quickly become unmanageable, so it is best to know what you are protecting against and create a strategy that suits your needs for the current market conditions.
