CIC Column

Who's afraid of put options?

I am continually surprised at how many client advisors and investment clients themselves never or only seldom can or want to use put options on the equity market.I hear the same reasons and excuses for this again and again: too expensive, too late to buy, it isn’t worth my while, and many more. This supports the theory that most bank clients and many client advisors only want to invest in one direction: in the upswing. As a result, they focus on rising prices and find it hard to get to grips with the other side. This strategy seems to be ingrained, although everyone knows that the stock market is by no means a one-way street.

For information, put options are purchased as a hedge against falling prices. A premium is paid for this “insurance”. If prices do not drop within a specified period, the premium paid, i.e. the money, is lost. However, if the expectation of lower prices proves correct, the value of the put option rises in line with the price decline. The option holder therefore receives more than the premium paid.

Experience has shown that anticipated events often do not happen within the specified timeframe. In this case, the price paid is lost and the money down the drain. But this is an everyday occurrence in the insurance business. Especially now, at the start of a new year, our homes are awash with policy renewal letters for car insurance, buildings, health and household insurance.

Each time, we pay a premium for a specific period and when nothing happens during that timeframe, the insurance protection and the money paid for it is lost. This is a completely normal, everyday process that we are familiar with and therefore also accept. Why the same process is often not treated in the same way on the stock markets is a mystery.

At the moment the stock market is surprisingly positive. Share prices have risen since the start of the year, without well-known problems, such as the debt crisis in many countries, being resolved. It would therefore be a good time to take out hedges to secure the gains made early in the year. An important decision needs to be made, but how to go about it? This is where put options come in. Instead of selling equities, purchase the corresponding options and protect your portfolio for a defined period. The premium paid is likely to prove worthwhile and allow you to sleep better in turbulent times!

Markus Allemann
Head of Private Clients in Basel
This column appeared on 21.02.2012 in Basellandschaftliche Zeitung bz