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Rekenthaler Report

My Latest, and Most Impulsive, Trade

Here's how insuring with stock-index put options works.

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Reader Responses
Last Tuesday’s column discussed three prospects for those who are currently bearish: 1) short stocks, 2) move to cash, and 3) use options. I disliked the first two alternatives. So, seemingly, did that article’s readers, because I received no email defending either path. That’s progress. Back in the day, market-timing was popular but rarely successful. It seems that the lesson was grasped.

I certainly got an earful about options, though. Replies ranged from bemusement at my naivete; to enthusiastic descriptions of the writer’s personal options strategy; to worries about my mental well-being, because retail investors who consider using options are dotty, and I had not previously appeared to be dotty.

That final concern, as you will see, wasn’t far off the mark. But first some background. Through both business school and receiving a Chartered Financial Analyst designation, I was formally trained about options. Consequently, I understand their underlying principles, as well as the factors that affect their prices. That doesn’t mean that I know how to use them as investments, though.

Readers were delighted to fill the gap. My column had discussed buying stock-index put options as insurance against the possibility of further market declines. They responded not only by discussing put strategies, but also selling calls, as well as various buy/sell combinations, and newer hedging techniques using exchange-traded funds. Eventually, that material will work its way into a future column. Today’s article, though, illustrates how insuring with stock-index put options works in practice.

Taking Action
This I can discuss, because I now possess those securities. On Friday, I spent 2% of the value of my equity holdings on a put ladder. At the time of those trades, the S&P 500’s price was 2550. I invested 50 basis points each into four varieties of index puts: Those with strike prices of 2400, 2200, 2000, and 1800. The expiration date for all the purchases was June 30, 2020.

If your head is swirling, no worries. The big picture is simple. If I hold these puts until June 30, they will expire worthless if the S&P 500 price is above 2400. Below that level, the puts begin to generate gains, because upon their expiration I would receive the difference between the June 30 S&P 500 value and the put’s strike price.

Thus, if the S&P 500 value were 2100 on June 30, I would earn $300 for each 2400 put, $100 for each 2200 put, and nothing for the 2000 and 1800 puts. (Technically, I would receive different amounts than those figures, because the options contain multipliers, but the principle remains the same.) Should the index not just decline but plunge, sustaining a 33% quarterly loss to finish at a price of 1700, I would collect on all four rungs of the put ladder. Huzzah!

Well, not quite. For one thing, I am not ghoulish enough to celebrate others’ misery, should I turn a profit. For another, I would not turn a profit. This is merely a partial insurance policy. If the stock market loses money over the next three months, so will I. But I will lose slightly less money than the index should stocks perform poorly, and considerably less if they perform calamitously.

(The above analysis assumes that I hold the puts until the expiration date. That may not necessarily be the case. However, let’s set that possibility aside, because it complicates the story.)

Looking Foolish
Objectively, this transaction was rather silly. (This column’s headline was no joke.) Buying put options is a reasonable idea, but my timing was terrible. The recent stock-market crash has greatly inflated put prices. Consequently, even by spending a healthy 2% on three-month puts, thereby implying a fat 8% annual rate, I could afford only partial portfolio protection.

The truth must be told. I was a duffer, a patzer, a mark. Instead of buying low, I went high, after the performance had already been achieved. I could just as well have shopped at Nieman-Marcus. Consider this: A June 30 put with a strike price 20% below the S&P 500’s current level costs $90. Meanwhile, a June 30 call option with a strike price 20% above today’s index value trades at … $21.

Puts generally cost more than calls, because of the underlying options math, but the difference is rarely that large. My investment was distinctly nonvalue.

In My Defense
Here are my excuses. (Calling them “justifications” would be too strong.) First, I don’t plan to ever repeat this experiment, so I won’t face the law of large numbers. Making many such transactions would require me to be unrealistically accurate, to overcome the bad odds. For this wager, I only need to be correct once. If I am right and the trade succeeds, my profits will be less than if the puts had been better priced, but they nonetheless will be profits.

Second, I have never been so skeptical of the near-term prospects for equities. Despite sustaining severe losses, U.S. stocks remain at late-2017 levels, with not just the United States, but nearly all developed nations (as well as the larger emerging countries) facing prolonged business restrictions. Even with government interventions, a global recession appears to be inevitable. It doesn’t look to me as if stocks have fully discounted that development.

The strongest reason for this transaction, though, is psychological. I first contemplated this trade four weeks ago, and since have watched it succeed, rather spectacularly, without my participation. So far, I do not regret my inertia. Few investment ideas are enacted. However, I would be disappointed if I were to remain on the sidelines, and stocks were to decline further.

All that said, the trade is a chicken bet. It risks no more than 2% of the equity portfolio. Politicians rarely believe that they may be wrong, but researchers must constantly recognize that possibility. My analysis may be deeply flawed. If so, I will pay good money to learn that lesson--but the price is one that I can afford.

In the interim, at least I have the fun of watching the daily movements of a short-term trade, which is an entirely new experience. Consider this as part of my entertainment budget. Scratch that. For this shelter-in-placer, the put options are my entire entertainment budget.

The Longer View
As those who read Friday’s column know, my short-term skepticism is counterbalanced by my long-term optimism. American companies will adjust to the new reality, by devising fresh ways of delivering their goods and services. In addition, those fortunate enough to retain their jobs through the difficulties--which, it must be admitted, will be far from everybody--will have accumulated much pent-up demand. The economic recovery, when it occurs, should be swift.

I do not believe, however, that the stock market has fully anticipated the tribulations that will occur before we reach that point. In that, I would be delighted to be proven wrong.

I can be reached at john.rekenthaler@morningstar.com Sometimes my fingers grow wearing of typing, so I cannot promise to respond to every email, but I read them all.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.