Stocks quoted in this article:
A June 8, 2011, Smart Money article entitled, "How to Shop for Car Insurance," warns "It may be tempting to purchase only the minimum amount of liability (insurance) required by law, but experts warn against this as accidents can cost way more than you could ever expect." This seems like sound, sensible and rather obvious advice to anyone with a feel for the ever-ballooning jury awards in liability cases. But these days, some popular options strategies among large (and allegedly sophisticated) players for protecting (i.e., insuring) portfolios against disastrous losses seem to have ignored some fundamental insurance principles.
We all know the price of so-called "DOOM" options ("deep-out-of-the money" puts designed to protect against a crash) has been expensive ever since the last actual stock market crash in October 1987. The "negative skew" underlying the pricing of such options -- the extent to which out-of-the-money puts are priced with much higher implied volatility than comparable out-of-the-money calls -- has varied over the years, but paying up for such puts has consistently been a painful proposition. So, it's not surprising attempts are made to reduce the cost of portfolio protection. But it's also no surprise you get what you pay for, which turns out to be protection that, while "cheaper" in dollar outlay, can be described as illusory in the event of a true disaster.
For example, on November 8, 2011, an investor in the SPDR S&P 500 ETF (SPY) bought 50,000 contracts of the December 117-110 put debit spread for 85 cents with SPY trading at about $126 (per Trade Alert). Clearly, the December 110 puts were sold against long positions in the December 117 puts to reduce the cost of the portfolio protection. But what becomes of this debit spread strategy in the event of an off-the-charts market decline comparable to that of October 1987, in which the market shed 22.6% in a single trading day? This would translate into a decline by SPY from $126 to $97.50, but because the December 110 puts were sold to reduce the cost of protection, the post-crash value of this debit spread is limited to $7 (the 117-strike less the 110-strike) regardless of how far the market plunges. So, in effect, the investor is insuring against a modest decline in the market but is "self-insuring" the consequences of a huge market decline, which in my opinion defeats the real purpose of portfolio protection.
The lesson here is simple. If your portfolio can't take a modest decline, you should reduce its size. But if you desire crash protection, then pony up the cost of buying puts at a strike that fits your loss tolerance and over a timeframe long enough to avoid the cost of a repeated roll of your expiring position.
It requires a contrarian disposition to avoid flawed strategies to which the crowd gravitates. With this in mind, we decided to do an "encore presentation" on page 20 of my "Eternal Contrarian" piece from our summer 2010 issue, which provides actionable instructions on how to apply the contrarian take wherever and whenever indicated.
And based on today's elevated stock market volatility, it's important to understand intermarket relationships -- how different asset classes, such as bonds, currencies, stocks and commodities influence one another -- which can be found in "When One isn't Enough" on page 14.
To read the Winter 2011-2012 issue of SENTIMENT magazine in its entirety, please click here.