What do you do with your savings? While investing in property, assets, and bonds are a few options, the stock market is an excellent avenue to multiply your returns. However, there is always a risk associated. To reduce this risk you can start using Portfolio Insurance strategies.
“Everyone has the brain power to follow stock market
If you made it through fifth-grade math, you can do it”
-Peter Lynch – an American investor, mutual fund manager, and philanthropist
Why Portfolio Insurance
Stock portfolio risks can be controlled by getting Portfolio Insurance. Portfolio Insurance is a method of hedging a portfolio of stocks against the market risk by short selling stock index futures. Portfolio insurance is mainly beneficial in a volatile market where the market direction is uncertain. The hedge is used by having a security in the portfolio that is perfectly negatively correlated with the overall market. Hence, your portfolio may be down in a severe bear market, but performance will be significantly better than without the hedge.
Portfolio Insurance protects your investment
Portfolio insurance is not a policy but an investment strategy used to have a cushion against your risks. Hence, while you bet on the stock market being bullish – i.e, having an upward trend – you secure yourself by buying “put options” (an option to sell shares at an agreed lower price) insuring yourself against a bearish market – i.e. a downward trending stock market. With enough “put options” at the right price, the profit from selling them can offset most or all of the losses from a bearish market. If the market continues to be bullish and the underlying stocks continue gaining in value, you can just let the put options expire.
Total fund value: $1 Million Put options strike price: $1 Million Expiry date: 1 year Premium amount: $10,000
In the above example, at the end of a year, if the total fund value increases higher than $1.01M, your Portfolio will make the profit. However, if the fund value reduces lower than $1M, you would exercise the put option and regain funds invested through the profit made on “put options” and your loss will be $10,000 (premium amount).
Portfolio insurance may not be a win-win situation when your Portfolio is gaining a meager return or no return. This is mainly due to the costs (premium) involved in the put options. The factors that affect the price of an option are current stock price, intrinsic value, time to expiration or time value, and volatility. However, since the premium amount might range from about 1-5% of the total investment, it still makes sense to cover your risks.