Buying put options to protect against a market fall

[jwblue]

Is this a good strategy?

If not, why?

[madbrain]

Just how confident are you about this market fall ? And how do you know when it's happening ?

Put options have a cost. If the market is flat or goes up, they will expire worthless.

[jwblue]

Just how confident are you about this market fall ? And how do you know when it's happening ?

Put options have a cost. If the market is flat or goes up, they will expire worthless.

I don't know where it is going.

My portfolio has done really well. I want to hedge a possible fall.

[Johm221122]

I don't know how old you are but considering you might be investing till your 80 years old,how many market drops might you see?You maybe buying put options for 50+ years,I would just hold a portfolio I can sleep with and stay the course
John

[Valuethinker]

Is this a good strategy?

If not, why?

Generally not. The cost of the options rapidly eats up the gains from the strategy.

The market is fairly efficient in this. For a retail buyer and seller of options you get killed on the spreads. If the professionals cannot do it profitably (and long run, they cannot) then you, facing several times the dealing costs, are going to struggle.

If you want protection, you need to shift your money to safer options: ibonds, FDIC insured CDs, ST bond funds (US government securities). TIPS but the yields are lousy (and the prices volatile).

The only reason to buy protection in this way is to avoid a capital gains or other taxation problem-- eg if the US still has that 2 year 'short term capital gains' distinction, then to protect yourself until that time period is up. Ditto if say you have a large position in the stock of one company (say as an employee) AND you have your compliance department/ company legal officer's permission to do this (I cannot stress enough the importance of avoiding a breach of SEC rules in doing this).

People also write covered calls (trading away the upside in return for an income). Again I doubt at a retail level this pays off. Writing an uncovered call opens you to the possibility of theoretically infinite losses-- don't do. (I am not joking: Apple was a $10 stock, once).

[DualIncomeNoDebt]

Is this a good strategy? If not, why?

For the individual at-home investor, absolutely not. First reason: monster spreads and fees alone will eat a lot of your risk premium, hence you start from a losing position. No professional risk manager or derivatives trader purchases protection this way, which brings me to the second reason.

Second reason: the derivatives/ call-put options available to you via your brokerage are for novices, and exist to be gamed. Shadow banking is real. There's an entire universe of unique and tailored derivative products to protect against all kinds of events (like market drops), with all manner of complex and sophisticated products. Welcome to the world of ISDA and non-traditional product channels, where monied players get to write and tailor their own derivative contracts on terms far more favorable than you will ever see, including lower costs, lower fees, much lower spreads, and with times/durations ("tenor" in banker parlance) the home investor will never, ever get to purchase on an individual basis. Do not play this game, because none of this is available to you, period. Hedge funds, banks' "Delta one" trading desks, and banker proprietary trading ops need only apply. Options and derivatives is a trader's club, and you're not in it.

If you want to get just a taste of this, go and read "The Big Short" by Lewis. Read how hedge funds were purchasing super-cheap "puts" on subprime mortgage-backed securities, using individually-tailored and negotiated ISDA derivative agreements (credit-default swaps) to essentially purchase massive, long-term puts on subprime MDS, and they did it cheaply -- without the spreads, costs and fees you will be paying for your market puts. None of this was revealed or disclosed on any market at the time (see AIG implosion and resulting market detonation). Dodd-Frank tried to reign in some of these OTC abuses (e.g. institutions like AIG and Lehman writing enormous amounts of swaps they could never cover, resulting in massive enterprise risk which actually came to fruition as their balance sheets imploded, bankrupting Lehman and requiring a $170 billion AIG bailout) but we are a long, long way from anything approaching transparency.

[Ranger]

Is this a good strategy?

If not, why?

For a retail buyer and seller of options you get killed on the spreads.

I don't recommend anybody to buy put options. But, I have seen above statement made in several option threads. If the OP is trying to protect against the market, OP is probably buying index options. Bid/Ask spread in index options (like SPY, IWM,QQQ) is penny-wide at near the money strikes, which is same as bid/ask spread of etf. Regarding commissions Option trading costs have come down considerably. Take a look this link:
http://www.interactivebrokers.com/en/in ... p=options1

70 cents per contract, which is lot less than vanguard charges to trade 100 shares (around $7) of stock or non vanguard etf's. Also those published rates are not set in stone and negotiable based on the volume and frequency of trading.

Regarding taxes, if one trades big cash settled index product like SPX, RUT, NDX or Emini future options, it is treated as 1256 contract product and is taxed at 40% short term gain and 60% long term gain rate, much less than ST tax treatment.

Again it is not my recommendation to trade options or buy puts, just an clarification. These long premium play is not advisable in general because of time decay, It is preferable to have debit spread to reduce the cost of protection.

[grabiner]

Put options have a cost. If the market is flat or goes up, they will expire worthless.

I don't know where it is going.

My portfolio has done really well. I want to hedge a possible fall.

If you want to reduce the risk, it's usually less expensive to rebalance your portfolio to hold less stock than to buy put options. You pay a cost either way; if you go from 60% stock to 40% stock, you lose 20% of the stock market return, and if you buy put options, you pay the cost of the put options every time they expire worthless.

And you will have to buy put options repeatedly, even in a declining market. Suppose that the index is at 1500, and you buy a put option at 1200 to protect against a loss of more than 20%. The index actually declines to 1000 in the next year, and you sell your put for $200 so that you get back to $1200 and lose only the 20% (plus what you paid for the put). But assuming that you want to keep your market exposure, you now need another put at 800 to get the same protection.

There can be tax advantages either way. If you reduce your stock allocation, you will have to pay an immediate capital-gains tax, while if you buy put options, you don't have to sell any stock but will have a capital gain on the put if the market falls.

[Valuethinker]

Is this a good strategy?

If not, why?

For a retail buyer and seller of options you get killed on the spreads.

I don't recommend anybody to buy put options. But, I have seen above statement made in several option threads. If the OP is trying to protect against the market, OP is probably buying index options. Bid/Ask spread in index options (like SPY, IWM,QQQ) is penny-wide at near the money strikes, which is same as bid/ask spread of etf. Regarding commissions Option trading costs have come down considerably. Take a look this link:
http://www.interactivebrokers.com/en/in ... p=options1

70 cents per contract, which is lot less than vanguard charges to trade 100 shares (around $7) of stock or non vanguard etf's. Also those published rates are not set in stone and negotiable based on the volume and frequency of trading.

Regarding taxes, if one trades big cash settled index product like SPX, RUT, NDX or Emini future options, it is treated as 1256 contract product and is taxed at 40% short term gain and 60% long term gain rate, much less than ST tax treatment.

Again it is not my recommendation to trade options or buy puts, just an clarification. These long premium play is not advisable in general because of time decay, It is preferable to have debit spread to reduce the cost of protection.

Thanks you know the retail market a lot better than I do! (not hard ). I've never dabbled in the things, because I thought I could get my fingers burned off.

[Valuethinker]

Just how confident are you about this market fall ? And how do you know when it's happening ?

Put options have a cost. If the market is flat or goes up, they will expire worthless.

I don't know where it is going.

My portfolio has done really well. I want to hedge a possible fall.

Then take money off the table. I bonds, short term US govt bonds, ST TIPS, FDIC insured CDs. You can then view the rest of your portfolio as somewhat 'insured' by having done that.

[talzara]

The problem is not the spreads -- and certainly not the spreads on index ETF options. The problem is that the premiums are too high for what you're getting.

Major institutions can deal with the investment banks directly. The i-banks will write bespoke options that go out as far as 10 years. Warren Buffett wrote options for an undisclosed counterparty that ran out 20 years!

As an individual investor, you have access only to exchange-traded options -- which run out no more than three years. The short-dated options are the most expensive, in terms of annual cost. This is a very expensive type of protection. Essentially, you would continually be buying volatility protection, rather than protection against secular declines.