The following illustrates not a recommendation, but rather a thought process under such a scenario.
Sheryl decides that the equity market is becoming more and more vulnerable as the recent rally has been fueled by new investment by average U.S. investors. As the market continues to climb she worries that a declining dollar will eventually stall foreign inflows of capital (she notices that it may already have begun as the last two months indicate that foreign inflows of capital have not fully financed the trade deficit).
Buying a put is probably her best and most straightforward course of action to protect her exposure to equities.
First she chooses an index. Sheryl's equity exposure correlates highly to the SPX: she can either pick an index that highly correlates to this or an index that will participate to the downside by at least if not more than the index. She decides that under her scenario the financial stocks will under-perform the SPX. Puts on the XLF index are available and liquid, so she will not be over paying for liquidity.
Second she determines an expiration date for the put: this is a timing transaction where the expected movement must occur during the life of the put. Enough time must be given to allow for a reasonable probability for the expected movement to occur. Sheryl decides that nothing will happen through the end of the year. After the holidays, she anticipates that the dollar's erosion will continue and eventually affect the equity markets as end of year capital flows fade. She chooses March expiration.
Third she must choose a strike. The more certain she is that a move will occur, but that the move will be moderate, the more she will tend to an at the money strike. The less certain she is of the move, but that if it does occur it will be substantial, the more she will tend to choose an out of the money strike. This second scenario provides more leverage: she can buy more puts for the same cost. Sheryl understands that she may make no money if the move is only moderate. Sheryl decides that a move if it occurs is likely to be dramatic and so chooses to make more money at the risk of making none if the move is moderate. She chooses a strike of 26 with the XLF at $27.50; this strike is 5.5% out of the money (1.5/27.5). Sheryl views this as her deductible: the loss she is willing to incur herself before she is protected.
Fourth she must choose a notional amount to protect and a premium amount to spend. Sheryl's equity exposure is $100,000. If she buys 38 contracts, this will equal her notional exposure less her deductible (26 x 38 x 100 = $100,000). She then checks the price per contract, which is $.50; the total premium cost is then is $1,900. This insurance cost represents 1.9% of her assets.
Spending 1.9% of your assets on a three month insurance policy is a fairly high amount, even though the price of the options is fair relative to the volatility of the market. After weighing her concerns with this cost and the fact that she has to be very right on timing, Sheryl decides to buy only half the amount to insure her entire portfolio.
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