Proactive Risk Management Part 3

Published on 04/11/19 | Saurav Sen | 2,803 Words

The BuyGist:

  • This article is the same the as the detailed thesis put up in The Buy List.
  • Continuing from Proactive Risk Management, Part 1 and Part 2, this has all the relevant calculations necessary to make the final decision about hedging the portfolio. 
  • Two Options were selected as Portfolio Hedges.

Why buy a Put Option?

Just to remind you – a Put Option gives us the right (not the obligation) to sell an underlying security at a pre-specified price, known as the Exercise Price or Strike Price. In contrast, a Call Option gives us the right to buy an underlying security at a pre-specified price. The idea of buying Options is Risk Management – hedging the downside. The payoff from these Options comes from the ability to buy or sell the underlying securities in the open market at the Option’s expiration date. Yes, that’s the catch – there is an expiration date.  

Let’s focus on Put Options. We make money if the underlying security price dips below the Strike Price. That’s because we can buy the security (let’s say a stock) in the open market at the market price. But the market price is below Strike Price (the price at which we have the right to sell). So, we pocket the difference. But if the market price of the underlying stock doesn’t dip below the Strike Price, then we’re not obligated to exercise the options. Our downside – from just the Options trade – is limited to the cost of the Option. So, the question becomes: “How much will you pay to protect yourself from the downside?”

At The Buylyst, we’re looking to protect our portfolio from a market crash. So, a Put Option on the S&P 500 (SPX) was the best, well, option, in my view. It protects the portfolio in the event of a major market crash. But if the market keeps appreciating, the portfolio (presumably) gains and I get to participate in the upside because I hold stocks. Then the Put Options just die afte the Expiration Data. The catch there is that the Put Option has a cost – usually called a Put Premium. But if the cost is palatable, I’ll be fine with it. The question again is: “How much am I willing to pay for this protection?”

Please Log In or Subscribe to read the full article. Thank you.

We use cookies on this site to ensure the best service possible.