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Author: joelcorley Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1202  
Subject: Re: newbie interested in options Date: 11/26/2003 12:22 AM
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Tononi,

You wrote, I am interested in "an insurance policy" to guard against sudden loss if there are exogenous political factors that make the market crash. I basically view the market as solid in the next 6 months were there not these concerns.
I understand that I could buy a few put options ,say with an expiration in May on QQQ at the money, as a lot of my stocks are Nasdaq based. But if QQQ goes up I just loose money on the put, and were there something dramatic to happen causing the market to go down, I wouldn't protect my profits on my stocks as I'd just be making up the money lost on QQQ's rise. Hmmmm. How to proceed?


Yes, buying puts for a stock can effectively buy you insurance against the decline of a stock. Buying puts against QQQ provides protection against the combined decline of the Nasdaq 100 -- the 100 largest NASDAQ-traded securities by market capitalization.

If your own portfolio's performance tends to mimic the rise and fall of QQQ, then buying puts can help you insure against a loss in your portfolio; but it won't protect you against company-specific losses – unless your portfolio happens to consist of QQQ or of an appropriately weighted amount of the Nasdaq 100 stocks. How many put contracts you would purchase depends on the value of your portfolio, the market price of QQQ, whether or not any of your portfolio is leveraged and whether or not the average weighted Beta of your portfolio is greater or less than QQQ. Also, you may not want to insure your portfolio against total loss simply because buying insurance costs money.

Of course buying calls or puts can also be used to leverage your portfolio. This happens when you buy calls or puts that do not oppose an existing equity position in your portfolio.

Also, buying a put against QQQ might be an effective strategy for part of your portfolio; but then you may want to mix in puts or calls against other components that move contrary to QQQ. For instance, you might also hold oil or transportation stocks. Buying contracts against these components might help further reduce the risk associated with your portfolio.

Cost is the main advantage of buying several put options for a single index instead of buying contracts to cover each individual holding. That's because you can usually buy several contracts for only slightly more than what one costs if it's for the same security. However, buying a contract against an index when you're not actually holding the index only serves to protect you against general market forces and may not serve you as well as security-specific options.

Another reason for buying insurance through an ETF option contract is because contracts are not traded for every security. When that's the case, buying a contract in a related index ETF may be the next best thing.

You mention loosing money on a QQQ put if the market goes up. Actually, that's not entirely true. You need to view your holdings as a single collection and not just the option contract in situ. If the market goes up, it's true that you'll loose any premium you paid for the contract. However, the rest of your portfolio will receive an offsetting profit. Since your contract premium is fixed at purchase, if the market moves up enough you may offset the cost of the option premium by a significant margin. However, if the market falls, your option contract's intrinsic value will rise offsetting losses you experienced in the remainder of your portfolio.

As you can see, this strategy limits the downside risk associated with a holding or portfolio at a price. The price is the time-value of the contract at purchase. Eventually, you will exhaust the time-value of the contract and the only thing that will remain is its intrinsic value. If the market rises -- assuming you bought ATM or NTM puts -- the intrinsic value of your puts will remain at $0 and your only cost will have been the time-value of the (insurance) premium paid.

If instead the market falls, the time-value of the contract will still fall; but the option's intrinsic value will rise -- potentially offsetting (capping) losses in your portfolio. Even here, the real cost is the time-value of the contract. However, in this case the put contract will pay out -- much like an insurance contract -- an amount equal to the remaining intrinsic value of the put contract. Hopefully this amount will offset some, if not all of your losses in your 'insured' portfolio.

Does that make sense?

- Joel
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