Why You Shouldn’t Be Afraid Of Options And Futures

Buy-and-hold is the standard investment advice for rookies. They tell young people to grit their teeth through bear markets like those of 2001 and 2008 where some investors lost half their savings. They say you will eventually make back your losses over time if you stay in the market. They call that “diversification across time.” They suggest old folks like me should have most of our money in good bonds because we don’t have the time left to make up for losses, but we can’t do that because the Fed has forced interest rates to near zero for almost a decade.

One reason that diversification across time is a bad idea for young people is simple math. If a market crash takes half your life savings, the market will have to double in order to make up your losses. That may take five years, but then you’re only back where you started and have missed five years of potential gains. The math looks bad.

Few investors would buy a $300,000 house and not buy insurance on it against fire, flood, tornados or hurricanes. A few more might go without insurance on a $100,000 BMW, but not many. Consider that the odds of a bear market in stocks that steals say 25% of your savings are far greater than your house burning down or totaling your BMW. Bear markets happen every decade. So why not insure your investment in the stock market as you would your house or car?

Professionals enjoy some fancy ways of protecting their investments, but for us average Joes there are just futures and options. I’ll discuss options because I’m most familiar with them. Whether you do it yourself or hire someone to do it, get some insurance on your savings in the market. It just makes sense, but especially so when the current bull market is so long in the tooth and elevated.

The basic way to protect your investment is to buy a put option. That option allows you to “put it to” the guy who wrote it, usually the broker you’re trading with. That means if you bought a put on the S&P 500 index SPY at 290 and the index fell to say 200, you could sell your shares of SPY to the seller of the put option for 290 and avoid the loss. That’s called exercising the option.

Most of the time option buyers don’t want to exercise the option and will sell it and collect the gains to offset losses in the market. If you bought enough options to cover the shares of SPY that you own, the results will be about the same. One option will insure 100 shares, so buy enough options to cover the number of shares you want to protect.

Plan to buy in-the-money puts. That means the strike price of a put option is above the current price of the index you hold. The strike price is the price you can sell stock to the writer if you exercise the option. In-the-money puts ensure that the price of the option will change in step with the change in the price of the index. Out-of-the-money options will change less than the index and provide less protection unless the market makes a very large move before the option expires.

Don’t be fooled by the cheapness of out-of-the-money puts. You get what you pay for. If you pay peanuts, you get monkeys. You want real insurance, so pay for it by purchasing in-the-money put options.

Buy put options before the market crashes. Volatility increases the prices of options as much or more than price changes. You want to buy before volatility spikes or you’ll pay dearly for the protection.

You can buy options that expire in a week, a month, several months or multiple years. Most investors should opt for the longer-term options, at least a year until expiration. Longer-term options vary more closely with the underlying stock or index than short term ones and decay in value less quickly. Short-term options are designed for speculators hoping to make a quick buck. Instead, you want insurance. Longer-term options act more like insurance.

If you buy a one-year put option that’s in the money and the market collapses before the option expires, the price of the option will rise enough to make up for most of your losses in the market. You can sell the option and cash in those gains. If the market doesn’t fall, or it rises further, the price of your option will continue to erode until it expires worthless. In other words, it works much like term life insurance, or house and car insurance that you must pay a premium for every or it expires whether you use it or not.

Poorly educated financial writers have made the public afraid of tools such as options and futures, but futures contracts have been around for about 500 years. Dutch farmers and merchants invented those centuries ago to protect their businesses from huge price swings. The prices of farm products would be high in the winter when farmers had little to sell and plummet at harvest time. Farmers wanted protection against the low prices at harvest while bakers and grocery merchants wanted protection from high prices in the winter. So they came together and created futures markets. Options are just a variation on futures.

If you want to learn more, I highly recommend the book Options as a Strategic Investment by Lawrence G. McMillan. Do it yourself or hire someone to do it for you, but do it before the market crashes.

First published at Townhall Finance.