May 18, 2010

Options as insurance

The previous post stirred the pot quite a bit. I received several comments, which I will try to respond via this post. I wrote about my general thought process without getting into the details of the strategy. I will try to explore some thoughts around that in this post.

Strategy not executable in India
Let me clarify something at the outset, namely that the strategy of buying deep out of the money puts to hedge against extreme events (or black swans), works well with long term options. As far as I know, we only have 1-3 month options in India. I think these options are quite fairly priced and any chances of making money on these options due to mispricing are lower than winning a lottery.

I bought some options once (miniscule amount) to just experiment a bit and I think it is very unlikely I will ever buy short term options to hedge or insure my portfolio.

The strategy in my previous post would work well with long term options with durations greater than 9 months. These kind of options are available in the US market and called as LEAPS. I don’t think such options are available in india yet, so I think my strategy would continue to remain on paper till we have such options.

Justifying an approach
I received several comments and more emails which implied that I wanted to dabble in options and I was justifying it by wrapping it up with the logic of value investing. That may very well be the case, though I consciously don’t think so.

Let me give you an analogy. When we buy a car or a house, don’t we buy earthquake or accident insurance? We don’t hope for an earthquake so that we can collect money on the insurance. The purpose of buying insurance is to protect our asset against extreme events. In order to have this peace of mind we end up paying 0.2% or higher of the asset value as insurance.

Long dated, deep out of the money put options can sometimes serve the same purpose. The trick would be to buy when the premiums are low and the market does not expect the crisis. Ofcourse this is hardly do able in India.

Investing for the thrill
I don’t think I am in for the thrill. I have invested in options a few times and you cannot believe the agony I have gone through during the holding period. Options lose value with time, which is called as time decay or Theta. So if you have a 3 month option, you will lose 20-25% of the value in the first month (with everything else remaining the same). As a result, it has pained me to see my options position lose value everyday.

So with options one has to get the timing right too. I am almost 100% sure that I can never get the timing right. So it is unlikely I will buy options repeatedly to try my luck in the market.

Short term hedge
I would rarely want to hedge my portfolio for the short term via options. My approach is to sell overvalued positions or hold on to it through a market drop if I am convinced about the company. As some of you commented on the previous post, buying short term options would just be a waste of money.

All of the above discussion does not mean one should not learn about options. I think it is a topic one should explore and learn. There are quite a few interesting possibilities with long term options, especially during extreme market peaks or bottoms. That ofcourse is a separate topic in itself.


Neeraj Marathe said...

Hi Rohit,
Long term options are available in India, currently limited to only index (nifty) chk them out on NSE website..options upto June 2013 are available, though liquidity is non-existent for a lot of them..

vikas said...

Nifty Options are available till June 2013

But particular stocks options are only for 3 months.

Pradeep said...

I would believe that's the prudent and valid use of Options for an intelligent investor.

Sunny Talreja said...

Hi, your article put a nice perspective for aritcle, and demonstrated it's one of the ethical usage. But, I still believe options are for speculators. For your insurance, its better to diversify the portfolio with other instruments like gold or divesify it across multiple sectors.

CCGemini said...

In simple words explain what is 'stay invested long term"...

Navjot Kashyap said...

Your idea is excellent.It can easily be used in many ways.For e.g. suppose you invest today and after 3 months you have unrealized profit of say 30 percent.Now you hedge it at this point.Buy 1yr foward LEAPS.After that,suppose your profit increases by say 30 percent more in the next 3 months.Then you can buy more LEAPS,1yr foward from that date.You may decide not to buy more,depending upon profit.In this way you can fix the time frame and percent profit variables and keep going on with your Insurance.Here I took 3 months and 30 percent,as example.
So,you will never loose your profits.The world can go to hell,literally.
The catch here is that,it works only with long term options.My guess is atleast 6 months min.Ideally 1yr.NIFTY Leaps are there till 2012 but they are liquid only till 3 months foward.
Secondly,they are available only for NIFTY.Obviously your portfolio will have midcaps,else why have a portfolio in the first place.So,the more your portfolio's performance divulges from NIFTYs,the less the accurate hedging would be.Still it won't be that bad.
Thirdly and the most important is the premium you have to pay.NIFTY at 5000.Lot size 50.You can pay 50 premium,max 100.Anything more is too much.But, here on 1,2,3 months contracts,the premium is 200,400-you can't pay that much.
All said and done,its excellent approach,if can be executed.
Do,you know how contracts are enabled for trading.Can't,lets say 50 people request the exchange to enable them.

mkd said...

Hi Rohit,

Read an interesting related strategy somewhere.

Since volatility is running high now, it might make sense to sell deep Out of Money PUTs on stocks that you like. Strike price should be below the price that you would be willing to own the stock.

Scenario 1 - Stock does not go down. You earn a nice premium since volatility is high.

Scenario 2 - Stock goes down below strike price and break even point. You buy equivalent stock and square off your position. You get to own the stock at (Strike Price - Premium), which was price that you were willing to pay in the first place.

Rohit Chauhan said...

neeraj/ vikas
yes there are long term index options available. i dont know how liquid they are and whats the spread on those options. also index options may be a crude way of building a hedge. it would work better if we had long term options on specific stocks

Rohit Chauhan said...

i dont think there any ethics involved in options. speculation yes

for a general investor i completely agree ..options are a bad idea and not good for diversification. other assets are better for diversification


Rohit Chauhan said...

Hi CC gemini
there is no fixed rule for long term. in my case long term is atleast 1-2 yrs and in some stocks i have it has been 8-10 yrs too


Rohit Chauhan said...

Hi navjot
you raise good points. there are multiple ways to execute the strategy. for starters one has to look at the pricing and duration of the option as you are paying premiums and too high a premium will cut your returns in the long run.

also volatility is important..premiums are high when voltaility is high.

i am looking more at buying deep out of money options when they are cheap to protect against extreme crashes. a 10-20% drop will not worry me and i would not do anything as the cost outwieghs the benefit


Rohit Chauhan said...

Hi mkd
yes thats a good strategy with deep puts. buffett has done for the stock he was interested in buying
diffculty is that you have is the execution. i think brokers will require you to hold collateral in the account as you selling naked puts


rayhaan said...

hi rohit,
ok maybe temptation might b just a bag of papers especially considering the mgmt s comparitively low stake .
i didnt get wot u meant by looking behind the numbers i mean wereu saying as my uncle repeatedly warns CAN U TRUST THE ACCOUNTS ( he also ends up trusting only psu and tata stocks) or were u pointing out that the incentives r not so good for the mgmt due to their low stakes?
even then panasonic carbon has 75% and flexfoods has 58% or is there some other reason
i mean look at panasonic
goodmgmt stake
stagnant sales
increasing eps and opm since last 5 yrs
it has like rs 96 in cash
so u r buying it a p/e of 6 and not 11 at its cpm of 160
p.s i d b really gr8ful if u kud temme bout ur stock picks wich have like remained cheap forever( especially if u have net nets)
nice to c barelkarsans link here
thx for replying atlast

Brijwanth said...

Your idea of insurance for portfolio is very good but the time frame may not suit your strategy much. even you buy 3 month option expiry using very small amount considering the leverage, it may not suit any one with smaller porfolio's. the portfolio must be larger than 2 lakh. options can be used by long term investors as insurance only if their portflio is largest else the insurance itself may cause a loss of 20% erosion in capital per year(provided all options fail). so either the time frame must be increased such as 1 year or 5 year options which act as an reasonable premium.

Rohit Chauhan said...

hi brijwanth
yes, you are right. for small portfolio, options are not a feasible option. when working with small amount, i think you should avoid options completely