Many retail investors sometimes become concerned about a decline in the value of their portfolio of investments but very few of these investors are aware of one simple strategy that institutions use to limit losses. This strategy limits losses by making a small investment that increases in value and pays cash when the market declines but loses its value when the market advances. The result is that the cash paid offsets portfolio losses and market advances pay for the small cost of the investment.
Too good to be true?
But it is true. Thousands of institutions and very wealthy individuals use this strategy to prevent losses of billions of dollars.
An Index Put answers this need. The most popular Index Put is the S&P 500 Index Put.
Introducing the Index Put
The Index Put is simply a contract between investors, secured by cash or credit with a brokerage firm. Under the contract, one of the investors (the seller of the Index Put) agrees to pay the other investor (buyer of the Index Put) for any declines in the index. The buyer investor pays the seller a fee for entering into the contract. This fee is a small proportion of the value of the index, generally between 1.5% per month. The seller keeps the fee and deposits the cash or securities required to pay the buyer with the brokerage firm. Historically, the seller has the distinct advantage since over 85% of severe market declines are recovered within three months.
The investor seeking portfolio protection is the buyer of the Index Put.
The seller benefits because he/she does not expect the index to lose value, while the buyer expects the value to decline more than the amount of the fee. An important added benefit for the buyer is that his/her portfolio need not be disturbed since declines are offset by the cash payment from the Index Put.
An example of how this works.
An investor named Nelly is concerned after hearing market forecasts and predictions of recession and other dangers. She is tempted to cash in her investments, in case a market decline does occur. But Nelly is also aware that cashing out is seldom a good idea since markets often recover quickly and prognosticators are often wrong.
Nelly’s may be an appropriate situation for using an Index Put.
Nelly has an S&P 500 Index Fund that is currently worth $100,000 and wants to make sure this value is not severely compromised in the next month. Nelly’s advisor suggested that she buy one Index Put contract that would cost her a total of $4,407.
This way, if her S&P 500 Fund declines from its current value of $100,000 to $90,000 after three months, she would receive $29,310 in cash! If things became really bad and the value of her fund fell to $80,000, she would then receive a whopping $58,620 in cash to offset the loss.
If the prognosticators were wrong, and instead her investment increased to $120,000, there would be no cash from the Index Put, but the fund would be worth $20,000 more than if she had cashed out.
The following results are examples of various market losses and gains after one month assuming that:
- One S&P 500 Index Put contract is used (European Style) and held until expiration.
- The protected portfolio contains only an S&P 500 Index Fund that is valued at $100,000 at the contract date and accurately tracks the index.
- The S&P 500 is at 2,930 (strike price) on the contract date.
- Index Put is purchased on contract date at a premium of $43.97.
|% change in S&P 500
||Portfolio Value (after 3 months)
||Cash Paid for Index Put
||Cash Received from Index Put
Selecting the Index
The preceding example assumes the pairing of an S&P 500 Index Put with an S&P 500 Index Fund and in such a case the Fund is designed to be perfectly correlated with the index (Changes in the S&P 500 index cause identical proportionate changes to the Fund). While the correlation may not be as close to other portfolios, the S&P 500 Index Put can be used to protect any portfolio that tracks the S&P 500 closely but not precisely. With imperfect correlation, the net results may be marginally higher or lower.
The S&P 500 Index Put does not apply to portfolios that are uncorrelated with the S&P 500. In such cases, a well correlated Index Put is needed. There are hundreds of available Index Puts so there are likely to be several that are highly correlated to a specific portfolio. See the List of Option Indices included in this Guide.
For this and several other reasons, DALBAR has developed the Investor Panic Relief Tool (i-PRT) that matches the investor’s specific needs, concerns and preferences with an optimum Index Put strategy.
Investor Panic Relief Tool (i-PRT)
The i-PRT calculates the net results for investors based on the value of portfolio assets being protected from loss. These calculations use “Normal” factors that can be overridden for any given situation. These include:
- Term of the contract
- Index to be used.
The XSP S&P 500 Mini Index (XSP) is used by default and may be replaced by any of the following menu choices or by another user selected index:
SPX S&P 500 Index
SPX LEAPS S&P 500 Long-term Equity AnticipPation Securities
XEO S&P 100® Index (European)
DJX Dow Jones Industrial Average (1/100th DJIA)
RUT Russell 2000® Index RUI Russell 1000® Index
UKXM FTSE-100 Mini Index (1/10th UKX)
MXEA MSCI EAFE® Index (Europe, Australasia and the Far East)
MXEF MSCI Emerging Markets Index NDX Nasdaq-100® Index
NQX Nasdaq-100 Reduced-Value Index (1/5th NDX)
- Initial Index (Strike Price)
- Maximum Change (Normally 20%)
- Unit price (Normally 1.5%)
- Multiplier (Normally 100)
- Leverage (Normally 1.2 times portfolio value)
- Number of Contracts (Based on portfolio value and leverage)
- Brokerage Commission (Normally $15)
Index Puts are conventional investments that are available from most brokerage firms that offer stocks and bonds. The brokerage firms hold the seller’s cash or credit that may be needed to pay the buyer if the market declines.
Index Puts are considered “options” and are the counterpart of Index Calls.
While traditional put options are known to lack diversification, use leverage, are complex and would be very costly as a permanent fixture, the Index Put strategy avoids these hazards. Index Puts are based on the collection of stocks in the indexes, not individual stocks and they are therefore diversified. There is no leverage since they are typically fully collateralized by the seller’s cash or credit. Settlements are in cash, making their use simple since there is no need to trade any underlying securities. As for cost, the Index Put strategy discussed here is used only when there is unusual concern about market conditions.
Retirement plans that offer self-directed brokerage accounts may have Index Puts available, but even if they are not available, investors can obtain them independently.
There are tax considerations for using Index Puts, tax professionals should be consulted.
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More About Index Puts - FAQS
What is an Index Option
An index option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell the value of an underlying index, such as the Standard and Poor's (S&P) 500, at the stated exercise price on or before the expiration date of the option. No actual stocks are bought or sold; index options are always cash-settled and are typically European-style options.
Index call and put options are simple and popular tools used by investors, traders and speculators to profit on the general direction of an underlying index while putting very little capital at risk. The profit potential for a long index call options is unlimited, while the risk is limited to the premium amount paid for the option, regardless of the index level at expiration. For long index put options, the risk is also limited to the premium paid, and the potential profit is capped at the index level, less the premium paid, as the index can never go below zero.
American-style index options can be exercised at any time before the expiration date. European-style index options can only be exercised on the expiration date. Index options are usually European-style.
How Do Index Options Differ From Equity Options?
There are quite a few differences between options based on an index versus those based on equities, or stocks. In general index options are far simpler than the equity option.
First, index options typically can’t be exercised prior to expiration, whereas equity options typically can.
Second, the last day to trade most index options is the Thursday before the third Friday of the expiration month. (That’s not always the third Thursday of the month. It might actually be the second Thursday if the month started on a Friday.) But the last day to trade equity options is the third Friday of the expiration month.
Third, index options are cash-settled, but equity options result in stock changing hands.
What is an Index Put?
The buyer of an Index Put option has the right, but not the obligation, to receive the value of the underlying index at the stated exercise (strike) price before the option expires. When the owner exercises an in-the-money put contract he will receive the cash settlement amount (the difference between put's strike price and the exercise settlement value of the underlying index) in cash.
Potential Profit: Substantial and increases as the level of the underlying index decreases to zero.
Potential Loss: Limited to premium paid for the Index Put.
How Much Does the S&P Change in a Month?
This is a natural question that investors considering Index Puts have. This is important because the Put only has value if the index declines enough to offset the price paid for it.
The price is typically 1.5% of the value of the index, so only declines of more than 1.5% make them worthwhile. On the other hand, an index increase of over 1.5% is required for the portfolio value to offset the price paid for the Index Put.
The most recent five years are a fair representation of what can be expected:
- There were declines in 30% of months, 70% increases.
- The greatest monthly decline was 9.18%. The greatest advance was 8.30%.
- The average monthly change is an advance of .77%
- Changes of more than 1.5% occurred in 88% of months.
- Decreases of more than 1.5% occurred in 6% of months.
- Increases of more than 1.5% occurred in 6% of months.
The conclusions from this analysis are:
- There is a 70% chance that the expectation of a decline is wrong.
- A decline that fails to pay the cost of the Put is unlikely… 6%
- An increase in the covered portfolio value that fails to pay the cost of the Put is also unlikely… 6%
- There is a 12% chance that the Index Put strategy will result is a net loss.
Statistically, buying an Index Put is clearly a better alternative than cashing out a portfolio, but not as good as simply remaining invested.
What is Cash Settled?
Cash settled financial instruments pay buyers in cash instead of shares of the underlying index at expiration.
When an Index Put expires and the index value is below the strike price (the value of the index at the time the option contract was signed) the owner exercises the option and receives a cash settlement equal to the intrinsic value of the put.
This payment is guaranteed by an institution that holds cash or collateral of the option seller.
What is an Option Stop-Loss Order?
An order to sell an option when it reaches a certain price (the stop price). The order is designed to help limit an investor’s exposure to the markets if the fears or expectations of the market changes.
Here’s how an option stop-loss order works: first you select a stop price, usually below the current market price of the option. By choosing a price below the current market, you’re basically saying, “This is the downside point where I would like to abandon my plan.” In the case of an Index Put, a stop-loss maybe appropriate if the index starts to rise before it can be settled.
When the index rises the value of the Index Put falls. When this declines below stop-loss order price, the stop order will be activated immediately as an order to sell the put, seeking the best available market price at that time the order is triggered.
Any discussion of stop orders isn’t complete without mentioning this caveat: they do not provide much protection if the market is closed or trading is halted during the day. In those situations, prices are likely to gap - that is, the next trade price after the trading halt might be significantly different from the prices before the halt. If the price gaps, your downside “protective” order will most likely trigger, but it’s anybody’s guess as to what the next available price will be.
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