Insurance
I have been thinking about how to insure a portfolio and have been attacking the problem with options.
My thought process was that I wanted to risk no more than 10% loss from the price in January, and in January I would buy PUT options with a strike price 10% the current price, with an expiration one year away. This would insure that my portfolio would be worth no less than 90% what it was worth in January.
Good idea, and I am sure we all would have liked to do that last January.
The problem is that the cost to do this would be about 10%/year. No one can afford to give up 10% a year and still come out ahead over time. Even selling covered calls to offset the cost of the insurance, it seems like a lot of risk.
What I noticed, but have not fully researched, is that in the money calls might be cheaper long term, but more expensive short term. In the money options always cost more than out of money options, because they have intrinsic value. If they were executed immediately, the executor would be on the favorable side of the transaction. An in the money call option has a underlying stock price worth more than the strike price, so executing immediately would allow you to follow up with a sale for a positive return. It makes sense that an in the money option costs more than an out of money option.
So how does in the money options work for insurance? You would buy a PUT option with a strike price higher than the current trading price of a stock. For example, SPY is about $83 right now, and a PUT with a strike price of 100 is $17 in the money. If I bought a PUT with a strike price of $100, I could execute it immediately, and someone would pay me $100 for my $83 SPY. Now the PUT will cost more than $17, and the difference between the $17 and the real price of the option is the time value of the option. For a option that expires in a year, that time value should be quite a bit.
The question is, if I buy in the money PUTs, will the time value be cheap enough that I can afford to insure my portfolio?
