Broker Check

Does Using A Put Option Make Sense To Mitigate Against A Portfolio's Decline In Value

October 26, 2020

On our Zoom broadcast last Thursday evening (“Cocktails With Fred”) an excellent question was posed by one of our attendees. Specifically, what did I think of using a “put option” to protect one’s portfolio in the event of another downturn in the market.

Before getting into a discussion of this topic  and even getting too far into the weeds, let me just set some parameters: the question was posed by someone who did not have a globally diversified portfolio and whose consisted primarily of large company, dividend paying, U.S. stocks which she depended on for income generation. Essentially an S&P 500 bogey. So this is the portfolio she was looking to protect. I’m going to therefore exclude from this discussion international stocks and small capitalization stocks.

First, for those who may not be familiar with options and put options specifically, let’s just terms. An option is simply a contract between two individuals or entities to buy or sell something for a specific price for a specific period of time. A put option is an option to sell shares of stock or an index (i.e. S&P 500) for said period of time based upon a specific price. With a put option you are hedging that the price of the stock or index will fall in value so you can ultimately sell the put option at a higher price than you purchased it for. Obviously, the value of the put increases inversely to the decline in the price of the item subject to the option. OK, so how does this relate to the woman’s portfolio in question?

Think of this in terms of insurance. For example, one purchases homeowner’s insurance not in hopes of their home burning down so they can collect the proceeds but rather as a hedge against an occurrence that could hurt one financially if not insured. Similarly, with a portfolio as described one would look to protect the portfolio against a decline in value – or, at least, mitigate any loss by effectively purchasing an insurance policy on the portfolio (the put option which would increase in value if the portfolio’s or any individual stock subject to a put option fell in value because it provides you with the option to sell it at the previous higher price). You’re not hoping to collect on the put option just as you are not hoping your house burns down so you can collect on the insurance policy!

Now, as to the question whether such an exercise makes sense in the context described. The woman is collecting dividends to fund her retirement income. All that really matters is that the dividend checks arrive on time and that (hopefully) they increase over time to keep up with inflation. So the question I would pose, particularly since all insurance involves a premium that costs real money (obviously, one has to pay a premium for the put option and that cost detracts from the retirement/dividend income) is: assuming there is no compelling reason for the woman to be concerned what the portfolio is worth at any point in time – just the dividend income is critical – does it matter whether her $500,000 portfolio is worth say $600,000 or $400,000 at any point in time? Except for the fact that we would all like to see our portfolios increase in value – which is a psychological issue – It really matters not what her portfolio is worth but rather how much income it can generate.

Since income is really what is needed not an increased value of the portfolio it makes no sense to expend funds for a put option to protect the portfolio’s value. What does matter is the quality of the dividend income, how stable it is and the quality of the companies and their shares that are providing the dividend income! My advice would be to save the cost of the premium unless preserving the value of the portfolio for heirs or some exotic estate need was compelling. Again, the value of the portfolio is not the critical issue, the portfolio income is and a put option does nothing to solve that need and, in fact, because of the cost of the put option, it detracts from the portfolio income.

All of that said there is one caveat where my advice would change: if the income generation was a combination of both current dividends and shares being sold periodically then I would consider a put option since mitigation against a decline in value would be an important consideration for that particular investment income design.