How to Reduce the Cost of Purchasing "Insurance" Against a Stock Market Decline

The two most notable differences between institutional and individual investors might their focus on risk management and their understanding of market cycles. Many professional investors are saying 2014 could be the year for risk management to take center stage. There are a variety of reasons for this, including the notion that 2014 is the year the markets will need to digest the Federal Reserve's reduction of quantitative easing, and with the S&P 500 Total Return index up nearly 30% in 2013 following a 17% gain in 2012, it could be time for a new market cycle to take charge and allow the economy to catch up with stock prices.

Regardless of why one might focus on risk management, individual investors should know how to incorporate portfolio protection without excessive fees, costs, or complications. Let's compare the most popular method of portfolio protection -- purchasing a put option -- to utilizing a "debit spread," or purchasing a put option and then selling a corresponding put with a strike price further from the money.

Purchasing a put
At its most basic level, purchasing a stock put option is the most popular method to protect a portfolio. The most significant issue with this portfolio protection strategy is the cost. Just as insurance on your home or car has a cost, insurance on your portfolio can be pricey.

As a basic example, let's say your diversified stock portfolio had a value of $140,000, which is the exact underlying notional size of the option contract covering the S&P 500 (^GSPC -0.82%). If the investor wanted portfolio protection, they might purchase the at-the-money 1775 put option, which closed at 126 on Friday. At this closing price the cost to insure the $140,000 portfolio for approximately one year would be $12,600, or a whopping 9% of portfolio value. Note the difference in value as time decay impacts options value:

Note: Based on quotes during preparation of this article. Actual option costs change constantly and may vary due to transactional costs, varying bid-ask spreads and unpredictable volatility patterns.

The most significant component of the cost is the insurance time premium. You will notice that as time elapses, the value of the put options experiences what is known as "time decay."

To illustrate this concept, let's compare the value of the same options that expire in three months, six months, and one year into the future. In table one, you will note the value of the at-the-money 1775 option dropped nearly 35% of time premium value in six months (from December 2014 value of $12,600 to June 2014 value of $8,200, illustrated in red) and dropped nearly 60% given 9 months time (from December 2014 to March 2014). The further out-of-the-money 1475 has even worse time-decay attributes. The value of the 1475 option dropped nearly 39% in six months (from December 2014 to June 2014) and dropped nearly 86% of value given 9 months time (from December 2014 to March 2014).

Are there ways to reduce this exorbitant insurance cost?

Ask this key strategic question
To determine how to reduce portfolio insurance costs, start by asking the question: how much insurance do I really need? Do you need 100% coverage to protect against the stock market going to zero? This could be akin to purchasing car or homeowners insurance without a deductible, meaning it carries the highest price but the most protection.

The decline in the stock market was nearly 37% in 2008, so let's assume the investor determines they only want coverage against a roughly 30% drop in a portfolio value. How can this be most cost effectively facilitated using options?

The debit spread
One method to battle option time decay and reduce the cost of portfolio insurance is through the use of a "debit spread." In this example, the debit spread would purchase the closer-to-the-money put, at 1775, while selling a further out-of-the-money put, the 1475. The cost for doing this is calculated in table one the "spread" heading.

The benefit of engaging in a debit spread is it not only reduces the cost of insurance, from $12,600 when purchasing the at-the-money put, to $8,655. (To determine the cost of the debit spread, subtract the cost of the short 1475 put from the cost of the 1775 put. This is done for the reader under the "Spread" heading in the performance table.) Unlike making an outright purchase of a 1475 put, with the 1775/1475 debit put spread starts protecting the portfolio upon any move below 1775, although the spread reaches its maximum value when the S&P hits 1475 and doesn't provide additional protection below that level.

While reducing the insurance cost might be considered the headline, perhaps the hidden value is in how the debit spread holds its value over time. The debit spread lost roughly 23% of its value in six months (from December to June). Compare this to the outright purchase of a 1775 put, where it lost 35% of its time premium over the same period. The debit spread lost roughly 47% of its value over nine months (from December to March) compared to a loss of 60% when purchasing a naked 1775 put.

Another method to reduce the cost is to move the put further from the money.  For instance, purchasing three out-of-the-money December 2014 debit put spreads, buying the 1175 put and selling the 1075 put would cost at total of $1,560 for $30,000 of protection, but the position doesn't start providing insurance against losses until the S&P falls below 1175.

Investing is about making smart risk-management decisions
No one knows exactly what the future holds. With professional investors starting to consider portfolio positioning for 2014, it's prudent for individual investors to learn the core concepts of what works best and apply them to their own investing strategy. I have found that many sophisticated institutional investors rely on a set of simple fundamental principles when making their decisions. Once individual investors can understand this in a simplified format, it opens a new world of opportunity.