The economy is swinging back and forth; are we back in a recession, yes or no; will the weak governments now eventually default on their debt and when; will the Chinese soon pull out from funding US government debt and will they ever chip in money into the European Financial Stability Facility; will all this hurt share prices and my investment portfolio; how painful will it be; anything I can do about it? …. Such questions are floating around en masse in the big world of small investors. One answer is: Yes. Manage your risk and insure your investment portfolio. So then, how?

Some people have been predicting gloom for a while. Every so many months, news journalists tell us we just narrowly avoided an Armageddon (from things like a financial crisis, or a government debt crisis), others say the end of the Western World’s economic and political dominance is near (as the end of the Roman empire’s dominance materialised some centuries ago) and thus values and living standards will be washed down the drain, barbarians will ride through our otherwise so quiet rural valleys, interrupt our afternoon tea or the demonstrations for new forms of capitalism, finally take over the cities and beleaguer our skyscrapers. Again other experts point to the unique level of indebtedness of the USA and Europe and argue that one day (soon to come according to them) it all will end in tears with governments defaulting, currencies becoming worthless, economies imploding, countries and people alike falling into depression. So then, would that hurt your stocks and shares portfolio (stocks for Americans, shares for Europeans, others may choose)? Likely yes. Can you do something about it? Yes. Go and insure.

So there is indeed a real risk for share prices to fall. The main culprit is a multiple decades-long debt and credit binge in several countries and a massive hangover now after the party ended (already some years back). One scenario is that several economies will have serious difficulties to recover (is it the US one, the Greek, or the Portuguese, or the Italian, or the British, or better the French or more deservedly the British or who cares, all of them and some more?). They are suppressed by the need to finance an enormous debt burden and are further weakened by tough austerity measures imposed by governments that woke up to the problem.

In this scenario, the risk is that consumers cut down their spending simply because they struggle with their budgets. This reduces turnover in the retail sector, leads to tougher competition and reduction in prices. Generally less consumer demand leads to a cut in capital investments, fewer consumer goods need to be produced, prices of goods need to be reduced to entice those consumers to still buy (things they don’t need anyway). Factories will have overcapacity, thus long-term investment in equipment and machines will decline. Enterprises run short of profit and will lay off workers and employees, cut wages and salaries. Because of the economic malaise, the government has less tax revenue and given its effort to deleverage, it will face a challenge in dealing with unemployment (reducing it via big government spending and paying benefits – or not).

The vicious cycle may continue downwards, leading to more unemployment, potentially mass unemployment. Because the malaise is so bad and consumer debt has still not been paid back, people struggle with exactly doing so. Companies struggle with staying alive given the lack of consumer and investment demand. Everybody is in need of cash: cash to pay debt and cash flow to pay salaries and suppliers. Because of a lack of cash, everybody resorts to the same, smart idea: turning assets into cash by selling them. Everybody selling stuff with nobody really keen on buying it means that prices start to fall across the board. To get cash, investors in developed countries start to sell emerging market shares. Ergo, those stock markets crash – painful. Next the domestic stock markets crash as investors are looking to liquidize assets. If no extra paper money is dropped from helicopters on streets and people, then the prices of assets generally fall, starting a period of deflation. In such times, cash is king.

With deflation, stock markets tend to fall (have a look at the Japanese stock market from 1990 to 2010). With that, private investment portfolios and pension assets fall too. Your uncle’s mortgage stays at say $100,000 whereas his stock portfolio declines by 90%, say from $100,000 to $10,000. Anyway (without bothering too much about the uncle), the message is: In such a scenario, all your previous efforts to keep your assets growing through stock market investments have been in vain. Back to square one, now eating nuts and grass. (Typically such scenario ends with the currency becoming worthless, the government defaulting on its debt and a currency reform being undertaken. Old currency declared invalid from day X. Everybody getting a voucher to redeem a few new-age-dollars from the banks).

Above is only one of many possible scenarios. Another one is that central banks print so much money that the printing presses melt in the process, the land is flooded with money which then looks for goods to be bought and as the amount of goods hasn’t grown equally fast there is a lack of goods supply which drives up prices: inflation, or hyperinflation. Cash is not king anymore, it becomes worthless very quickly.

Above first scenario is just one motivation to figure out how to insure stock investments. Other reasons might be to simply protect capital gains made in your shares portfolio or to insure against black swan events (those that happen once in a lifetime: e.g. a tsunami + oil debacle + breakout of war + satellite making it through the earth atmosphere and its nuclear reactor falling on a main city or capital).

Enough of the motivation, let’s turn to insuring a portfolio of shares: through buying some insurance. The insurance product is called options, more specifically put options. The ‘insurance company’ is a financial institution, like Goldman Sachs, Deutsche Bank, UBS etc. Many of them are (as we see still) around to act as insurers. Ahh, shouldn’t you be worried about buying an insurance policy from exactly those companies these days? Well the answer is: If you are, then split your insurance policy into multiple ones and strike a deal with multiple insurers. Unlikely that all go bust together. More likely that one goes bust (for the government to set an example) and the others then buy some of the shattered pieces or all. If you aren’t worried, you may be right, as the banks are still benefiting from being ‘too big to fail’. Again it’s unlikely that the different nations’ biggest and most prominent banks are allowed to go under. For the next several months the systemic risk would still be too high.

Given a mixed stock portfolio with say a few individual shares (e.g. in Apple because of the iPhone, or Exxon because of the oil etc.) and some stock ETFs and mutual funds, ideally with a focus on a single market/country, we argue that this portfolio is somehow/roughly following the ebb and tide of the whole market, as long as the portfolio is reasonably diversified. Then a simple approach is to find an insurance policy, that insures against a drop in the overall market. The instrument that suits us is a put option on a national stock market index. Say we want to protect a portfolio of US shares, then we buy put options on the S&P 500 index. Or say, we feel a strong mysterious urge to steer a portfolio of European shares into a safe harbour, then we buy a put option on the EuroStoxx 50 index. That’s it.

How such an insurance policy works: When purchasing the insurance policy, one needs to pay its price, the option premium. That’s a fair thing in life. One has also to choose the excess amount, the sum one is willing to lose (let go down the drain) before the insurance payment starts to compensate one’s loss. That excess amount is much related to what’s called the strike price of the put option. That strike price tells us when the policy is so really kicking in and starts to compensate for any damage caused by fire in our stock portfolio.

All one needs to do then is the following:

1. Learning about the basics of options (e.g. stock options and stock index options). One needs to understand basic terminology and the factors which influence the value of put options (speak the value of the insurance policy, as that value, unfortunately, changes over time). Part of this exercise must be to understand how the following factors influence the value of the option on say the S&P 500 index: e.g. the current level of the stock market index, the strike price of the option, the level of interest rates in the market, the dividend yield of the stock market, the expected future volatility (or nervousness) of the stock market.

2. Registering one’s plan to trade in options with a broker, or getting a permission from the broker.

3. Familiarising oneself with how to purchase a stock or index put option via a broker.

4. Determining the dollar or euro or yen or … or £ amount of the stock portfolio one wants to cover with the insurance: $1000? $10,000? Your uncle’s $100,000? The assets in your pension account?

5. Searching for a suitable insurance policy, i.e. searching the web for suitable put options on the appropriate stock market index, e.g. the S&P 500, or the FTSE 100, or the DAX 30, or the ESTX 50. Many options will be listed by your stock broker for the individual markets. Suitable put options:

• Are relatively cheap compared to their brothers and sisters.
• Show a low assumed future nervousness of the market, that’s the ‘implied volatility’.
• Come with a small spread. The spread is the difference between the buying and selling prices in %. In case the insurer doesn’t make any profit from the policy itself, it can make a profit through the spread. If I buy the option today for $0.50 and sell it tomorrow for $0.45 back to the insurer, then the insurer has made a profit. Ergo: spread to be small.
• Meet your desired insurance period: Shall it be 6 months? 12 months? More?
• Are consistent with the excess amount of the insurance policy you are happy with. The higher the excess amount, the cheaper the policy. The lower the strike price of the put option, the lower its option price (= premium). So a trade-off needs to be found: Wonderful protection (low excess amount) at a higher insurance (option) price versus ok-ish protection (well, may have to suffer a degree of overall loss) at a more moderate insurance price.
  • Technically, finding the optimal trade-off means deciding on the most appropriate option strike price. When the S&P 500 index stands at say 1280, there are various put options available with different strike prices: e.g. 1200, 1175, 1150 etc. The choice can be made by using
    a) instinct,
    b) maximum total loss one is willing to swallow (e.g. say $2000 from a $10,000 portfolio should the S&P 500 index drop by say 50%, which would carry the portfolio without protection to say $5000),
    c) optimal reward/risk ratio where reward means how much such a protected stock portfolio can gain over the insurance period as any possible gain will be dragged down by the cost of the insurance; where risk refers to the maximum loss the protected portfolio can still suffer,
    d) expected loss, assuming e.g. probabilities for an up-move and a down-move in the market and
    e) any other fancy optimisation approach.
    A further consideration is to put a ceiling on what the insurance premium shall represent in percentage terms of the stock portfolio value: e.g. 3% or 5% or 6%?

6. Having picked a suitable put option (on say the S&P 500), looking up its details online to learn how it is going to react to changes in the stock market index level over time. An option is e.g. characterised by a few parameters, called the ‘Greeks’. Coincidence: To avoid the meltdown of a Greek stock portfolio, one can resort to index put options and in the way of implementing this strategy, the ‘Greeks’ as they are known in option theory will prove indispensable.

7. Given the put option details, plugging its key numerical figures into a stock option calculator as available on the Internet. A Black-Scholes option pricing calculator will nicely do the job. The purpose of this exercise is to check whether the insurance policy offer that you found so intriguing is actually a good one. You can check whether your calculator spits out a similar price. If the price you get offered via your broker is lower, good news; if it is much higher, bad news. Then stay away from the policy and look for a better one. Apart from this, one can also estimate what the insurance policy may be worth further down the road.

8. Next task is determining how many stock index options to buy: 10? 100? 1000? A simple formula exists that gives a good indication. It will spit out say 1402.7. Then be generous and go for 1403 put options to buy.

9. Finally, ordering the put options through your broker, say e.g. buying 1403 S&P 500 put options, strike = 1200, expiring in say 9 months, each option at a price of a few cents (but that may depend on the market and options on offer).

10. Then things are largely done, the insurance policy is ‘active’. If over the holding period of the option nothing bad happens, no stock market crash makes the headlines, then the policy will expire at expiration day. Premium paid. So what; is as is with insurance products. If the nuisance happens and bad economic news, war or similar cause a mega market crash, the policy is ‘in the money’. A way to get our claim paid out is to sell the put option back to the ‘insurer’, our option contract counterparty, or to try and sell it via an options exchange. Or for American options, we may exercise the option before it expires, meaning we exercise the right to get the payoff from the policy. Should against our expectation the stock market move stubbornly into new, higher and higher territory, not too bad either: the stocks and shares in our portfolio will be grateful for that, and the sooner we realise such major convincing change in stock market or economic sentiment, the better for us to sell the put option back to the insurer at a still decent price (as long it has good ‘time value’).

That’s in short a procedure to protect a stocks and shares investment portfolio. Why protecting it in the first place? Well, should disaster knock at the door, it might do so inconveniently over the weekend, we may not be fast enough to sell our good shares on Monday (or any other day too) or we may not even like to sell them if that generates lots of trading costs, commissions or taxes, or if the shares actually pay nice dividends (which we are not entitled to when we stop being shareholders).

Apart from above protective put, other ways exist too to get protection, or to turn assets synthetically into cash or hedge a portfolio. No end to sophistication. Still, the insurance concept seems to have been around in other areas of life too, for a long time. It sounds familiar, is often simple and sometimes even useful (when appropriate).

Disclaimer: The author is neither intending to give or is giving any financial advice.