How Put Options Can Hedge The Risk Of A Portfolio Collapse

25th Jun '15 by Ben Hobson

18 comments 13623 reads

Fear of an imminent market crash can cause chaos in the minds of investors. Faced with the prospect of seeing hard-earned gains wiped out, it’s understandable why some reach for the sell button and seek safety in cash. Yet the temptation to trade out of shares can be costly. Unwinding positions means taking a hit on the costs of dealing spreads, crystallising capital gains liabilities and even missing out on dividend income. One way of tackling this problem is to resist the urge to sell-up and hedge the portfolio instead. Among the most common ways of doing that is to use a Put Option.

Back in 2008, fund manager Gervais Williams, then at Gartmore (now at Miton), managed to protect his small-cap growth fund from the worst effects of the market crash. As market valuations fell, Williams managed to offset most of the losses that were racking up in his fund. To boot, he ended up with a considerable cash war chest to buy up what had become cheaply-priced assets. All this was done with the help of a Put Option that he’d been holding for a few years (and something that he has held in his funds at Miton over the past year).

What is a Put Option?

In the vocabulary of options trading, a ‘Put’ is a bet on an asset falling in price. Puts can be used as an outright bet on falling asset prices, or more commonly to “hedge” the downside risk of a share portfolio without having to sell any of the underlying assets.

In the case of portfolio hedging, an index Put Option acts much like an insurance policy. It can be bought through a trading platform or as a spread bet or contract for difference - with the potential to add leverage to the trade. It’s a contract that gives the buyer the option - but not the obligation - to sell an asset at a pre-defined ‘strike’ price. It could be an individual stock, a sector or an index. In the case of Gervais Williams it was the FTSE 100.

As Stockopedia’s Paul Scott has noted, Put Option contracts can be expensive to buy and often end up worthless. Yet they do offer comfort in the face of a possible market meltdown.

Dynamics of a Put Option

Buying a Put Option involves paying a premium to the Put seller - who is…

Unlock with Email

Unlock with Google

Already have an account?
Login here

mrwhits

25th Jun '15

Good write up and bang on time, possibly , for the next downleg whenever that happens.

Would it be possible for you to give a "worked" example, say to hedge a mixed portfolio of shares worth say £100K against the ftse all share, or ftse 100 indexes, i.e. how you would work out how to get that level of protection.

Regards

mrwhits.

David Brightside

Very interesting intro to put options. Many thanks.
2 points:
(i) in the illustration, you mention how Mr. Williams protected his position by taking a put on the Footsie 100. Does that mean his fund was a tracker (in order to ensure a match)?
(ii) for a private investor with portfolio of individual stocks, should you take out puts on each stock?

Ben Hobson

Hi David,

It's an interesting one... the Gartmore Growth Fund originally bought the Put in September 2005 and it cost 1.6% of assets under management at the time, and the expiry was later extended at least once. But it raised eyebrows because Gervais was benchmarked against the FTSE SmallCap. When that index started falling in mid-2007, the FTSE 100 Put didn't have much of an impact. It was only when the FTSE 100 fell hard in 2008 that the Put worked - and the fund cashed it in for £16m. Without knowing the costs - likewise in relation to your second point - a Put on the FTSE 100 was perhaps the most cost-effective way of arranging protection against a big market correction.

Rusty2

Is the 1.6% per annum? How much were the assests worth? How is the amount calculated, if market falls 10% you get 10% of your assests value back?

cycle

I'd like to second the questions from herbie47 and mrwhits above - can you give a rough example of how this would work in practice for a 100k portfolio. Very interested in this at the moment as the US market looks considerably overvalued.
Thanks for the great article.

I could see how you could use "short" ETF's for this, and gain £100K downside protection, i.e. buy enough of them to cover 100K loss if the FTSE100 went to zero, but you need a CFD account for this, and most people dont bother with CFD's etc.

I guess though, you would need some CFD/Derivitives/futures based account to do anything like hedge short.

Someone mentioned two short ETF's on here the other day, one for the FTSE100 and I think one for the SP500, anyone remember?

Regards

mrwhits.

hmmm....maybe not then....

http://monevator.com/short-etf-maths/

regards

I think it may have been a DB-X tracker FTSE short. I was looking at those as well.

Just spoke with IG who basically say that Put options aren't available on major indexes for amounts sub-£100k. They said you need to be looking at a minimum trade size of £125 per point, which works out as needing to hedge 500k+ for a Put option on the NASDAQ which carries a premium in the tens of thousands of pounds (depending on strike price.) Seems you need to be an investor with a bigger pockets to do this kind of hedging, or am I missing something? Does anyone know of how to purchase a Put Option or Covered Warrant (perhaps through a CFD or similar) where you get the benefit of the option system (i.e. limited downside) which is a distinct advantage over a short...?

cig

There's plenty of sub-£100K contracts on the main exchanges. The FTSE is "£10/point":

https://www.theice.com/products/38716770/FTSE-100-Index-Option

To give a worked example, for the SP500 where I have prices handy, protecting a >25% fall this year, by buying the 1600 December Put would cost about 9 (index points) at the moment, thus approx 0.4% of the notional. The payoff is 1600 - index level on expiration day, or zero if the index closes above the strike. (All times the price per point, $100 or $50 for popular SP500 contracts.)

Buying deep put options regularly is not usually profitable (premium > protection payoff in the long term, as you'd expect for an insurance-style product) so it's best done either by people confident of their market timing skill, or as a substitute for a cash component in a portfolio.

Might be best just shorting the index of choice rather than use an inverse elf etc.

You would then have to just work out your exposure for your hedge amount.

As regards £/point, forget it, Paul will tell you the perils of spread betting , a short cfd might be worth looking at.

Regards

Mrwhits

jimbobjames2002

Fascinating article for a simple soul like me - thanks Ben. Just another query - is there a maximum time limit that a put option can be open for?

Thanks

James

Novice Investor

The perils of spreadbetting are using too much leverage and taking large positions in small companies that you can't unwind quickly. That's why Paul got hit, together with certain companies increasing their margin requirements, just when you can least afford it.

There is absolutely nothing dangerous about spreadbetting per se!

NI

Thanks, cig. Much appreciated. I found your last comment about using them as a 'substitute for a cash component in a portfolio' very helpful. That's what I'm looking for - a way of continuing to be fully invested during the last stage of a bull market to benefit from the gains, whilst still protecting against downside risk of a sudden bear market. I figure that they would not be profitable if you always used options for hedging but could be worthwhile if they're used only towards the end of the bull market cycle (which we seem to be approaching).

I just need to work out the mechanics of how these options are actually sold now through the main online discount brokers. None of them seem very clear about what's available and how best to set up an option with very little clear information about pricing and availability it seems.

Edward Croft

24th Aug '15

I thought I'd bump this thread given the market volatility. Very good timing recently by Ben to focus on hedging out market risk with put options. I'm sure everyone would be interested in people's stories of how they've been managing the downside. Safe investing !

PhilHofGrowYourDough

What about using The Naked Trader's strategy of using the FTSE 100 Super Shorter http://www.stockopedia.com/etf-prices/etfs-ftse100...

Alanjames999

There are hedged gold ETFS, so investment into fear is a hedge against a dropping market :)

Cjenkins8

18th Feb '18

perhaps an update is in order
i have reduced my downside recently by using covered warrants in my sipp - although hargreaves have recently obstructed more purchases citing new eu regulations
a good book is tail risk hedging by vineer bhansali

How Put Options can hedge the risk of a portfolio collapse

What is a Put Option?

Dynamics of a Put Option

Unlock the rest of this article with a 14 day trial

About the Author

Ben Hobson

18 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...