Introducing Convexity Using Put Options
Learn how to introduce convexity into a stock portfolio using put options.
All portfolio managers aim to create and maintain portfolios that gain when market conditions are good and lose little or no money when market conditions are bad. Yes, that sounds like what every trader and investor would love, doesn’t it? Such portfolio or positions are what professionals call “convex”. A convex position or portfolio would have greater volatility to upside than downside and has been hailed as the holy grail of portfolio designing. Convexity was once tough to achieve but with recent derivatives innovations such as put options, convexity is not only achievable but easily performed even by amateur investors.
There are three levels of risk in the capital markets; Systematic, Secondary, Idiosyncratic.
Idiosyncratic risk is risk to your portfolio when a single company stock fails. Secondary risk is risk to your portfolio when an industry as a whole fails. Systematic risk is risk to your portfolio when the overall market fails.
If you have a diversified portfolio of stocks, you should be able to minimize the effects of idiosyncratic risk or secondary risk as holding different stocks across multiple sectors protect your portfolio in the case when a single company or industry fails. However, there is one risk that can never be diversified away and that is systematic risk. Yes, despite what anyone tell you, systematic risk cannot be diversified away no matter how diversified a portfolio is. That is why your portfolio value will decline dramatically in a market crash no matter how diversified it is. Truly, there is almost no way to produce convexity in a stock portfolio under every condition without the help of insurance derivatives such as put options.
What are put options?
Put options are derivatives that gives you the right, but not the obligation, to sell the underlying stock at a fixed price. Yes, put options act like insurances! For just a small fee (known as the option premium), you can buy protection for your stock portfolio to prevent it from ever dropping in value! Yes, convexity at its best!
Lets take a single stock for instance. Assuming you bought 100 shares of ABC stock at $50 per share. At this point of time, this is a position without any convexity. This means that the value of the position can fall all the way to zero and it can rise as much as it can fall. Now, assuming you bought 1 contract of put options covering that 100 shares of ABC stock at $50, you would have incurred a small “insurance fee” but would have prevented the value of your position on ABC against any drops at all! A position that cannot lose money! Yes, that’s a convex position! If ABC stock continues to rise, the put options simply expire on its own when time is up and you would not have to spend a cent more on those put options. Just like insurance.
Now, if you have a totally diversified portfolio covering almost all of the 30 Dow component stocks, all you have to do is to buy put options on the DIA, which is the ETF for the Dow Jones Industrial Average, in order to protect your entire stock portfolio against a decline in value!
Even though you pay a fee for those put options, it is a very small fee compared to what you can lose if the stock should fall in a crash and would certainly help you sleep better every night.
Yes, convexity can be introduced into any stock portfolio simply by buying put options as protection for your portfolio. Learn more about put options at https://www.optiontradingpedia.com/put_options.htm .
