Aniruddha brought up a very good point in the comments and as a result, I decided to add it to the post as it captures the issue for a long term investor. My response follows the comment
i also tried with options while ago. I realized that, i would never sell my portfolio. So even if it is hedged by options, it's waste of money. If market falls you would earn money through options but that time you will not sell your entire portfolio. Option Profits would be offset against your virtual loss. Same thing with advances. The gain in the portfolio is offset with the option premium you pay, which would expire worthless.I found it good tool to earn money in volatile market for traders.
As i said, for a long term investor, options will not make sense unless one plans to sell in the short term. Here again it may make sense to just sell and not get too clever with options. so options is still an area i am trying to figure as part of my portfolio.
If however one is managing money professionally, options can help reduce short term volatility, which is critical for clients who may not have the emotional fortitude to bear huge swings in the portfolio and may pull their money out at the wrong time.
Options work well as disaster protection too...end of 2008 if you thought icici was going down the tube and had deposits, then puts would have helped. I bought those options to protect my deposits with the bank and it was more of an insurance, than a trading position.
I recently wrote on my purchase of options for hedging purposes and received several comments and emails on it. I discussed about the ‘what’ of the transaction, but did get into the ‘why’ of it. So let me discuss about it a bit here and then try to give a response to the various comments on the previous post
The why of options purchase
As I stated my previous post, the only scenarios where options would make sense for me are
· The market appears considerably overvalued and options are underpriced due to low volatility: This is a valuation and not a timing decision. However it is not a decision based on deep fundamental analysis. As the market gets more overvalued, I can reduce my long positions and the put option acts as a backstop for me. So in this case I am paying a small premium to protect myself from the downside, as I reduce my holdings and benefit from the upside in the interim.
· I wish to hedge a specific stock position which I plan to sell in the next few months: In such a case, I would prefer to buy a put option on the stock to hedge my open position. This is a hedging position and has no element of speculation in it. I am basically paying a premium for an insurance (against the stock dropping below the strike price)
In both the cases, I am paying a small premium for ‘insuring’ my portfolio for the short term as I sell the overvalued position. If I were to do this multiple times, I would expect to lose money on my options with the benefit of protecting my portfolio from downside while I am reducing my holdings.
In the past one month, I was lucky to have sold my open positions and then have the market drop a bit, due to which I was able to close out my options at a decent profit. I was lucky and not smart in this case.
Aren’t you speculating ?
I cannot deny that there is an element of speculation here. However I did not create a position with that in mind. As I said earlier, if I were to do this multiple times, I expect to lose money on my options positions with the benefit of being able to hedge the downside. If the market does crash, then the options positions would reduce my losses and thus reduce volatility of my portfolio. Speculation depends on the objective of a position and not on the nature of the instrument.
The cost of short term options is around 12-13% (annualized) for a downside protection for 10%. It would stupid of me to hedge my portfolio using options on a regular basis. Yes, the market is efficient in this aspect.
Why not buy long dated options
For starters, I looked for long dated options and was not able to buy them. The second key point is that the price of long dated options is very high. There is no point in buying a 10% downside protection for 1 year and pay 15% or more premium for it. In such a case, I am better off selling the open position itself. I see option protection useful only if I wish to buy short term protection in an overvalued market with clear plans of selling the overvalued positions during the same period
Some readers pointed out that I bought an index put where as my portfolio is mainly midcaps. Well, my disclosed portfolio is mid-caps, but not necessarily my entire portfolio. I do have mutual fund holding and Infosys stock and hence an index hedge is good enough for me. I have disclosed my portfolio in the past and the associated disclaimers.
I am in a learning and exploratory phase in terms of options. Options basics and pricing is easy to understand. The difficult part is to build a sensible strategy around these instruments and use it properly. My positions in the past have been miniscule (<0.5 %) and a gain or loss is more or less a non-event.
I will continue to read and learn and may dabble in these instruments a bit in the future. I see the utility of these instruments in arbitrage positions, but continue to be doubtful in terms of their utility for my core portfolio.
The other day, as I was discussing my options plan with my wife, she summarized it well – All boys have their toys, in my case they are options.