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Insure Your Equity Investment From Stock Market Corrections

In recent months, stock markets have seen a sudden and sharp upsurge. All the indices are trading at life-time highs.

Unfortunately, the economic growth has been rather sluggish. Consequently, the corporate profits have been poor.

As such, the market valuations have become quite expensive.

Therefore,
- either the company earnings have to improve dramatically in the coming months,
- or the stock markets have to correct from these steep elevated levels.

In either case, the returns from stock markets — in the near future — are likely to be subdued or even negative.

Beware: This doesn't mean that you have to completely exit equity; or stop further investment in the share market.

Since it is impossible to predict market directions in the short to near term, exiting or pausing is not the right approach to equity investment.

Instead: What is required at this stage is EXTRA CARE.

I had discussed all this in my recent blog post 'Should I Invest In This 'Overvalued' Stock Market?'.

Further to that, what you can do is to take some risk protection measures. This would ensure that your gains till date are protected. Or at least the loss, in the event of a sharp correction in the stock markets, is restricted to more palatable levels.

Rebalancing the portfolio is, of course, the most common risk management strategy. If your portfolio has become overweight on equity, compared to other asset classes (e.g. debt, real estate or gold), you need to sell part of your equity investment and reinvest in other assets. That's one option.

Even within equity, your portfolio would have probably become overweight on mid and small cap funds / shares. Hence, to de-risk the portfolio, you need to sell part of the mid and small cap investments and move to large-cap funds / shares. Since large-caps have the tendency to fall less and recover faster, your portfolio risk is reduced. That's the second option to protect your equity investment in these overvalued stock markets.

The third risk management strategy is to buy insurance.

put-option-portfolio-hedging
Have you protected your precious equity portfolio from market shocks?

Of course, there are no insurance policies to protect your stock markets risks.

Instead, what you have is the derivatives markets i.e. the Futures and Options or F&O. While most people use the F&O market for day-trading to make some quick money (NOT RECOMMENDED AT ALL), its role in hedging or protecting the portfolio risk is often ignored.

Let's explore this hedging strategy:

Suppose your equity investments — through shares, mutual funds and / or ULIPs — is currently valued at about Rs.10 lakhs.

If the markets were to correct by 5%, you will lose Rs.50,000. At 10%, the loss will be Rs.1 lakh. Likewise, it will keep increasing to say Rs.3 lakhs at 30% market fall (which is not uncommon).

Your objective is to NOT LOSE so much money, in the unfortunate event of a market crash.

This can be well achieved by BUYING PUT OPTIONS.

Put Option is a contract, wherein you get the right to
a. sell a particular security (or an index)
b. at a predetermined price
c. on or before a pre-decided date.

Just as equity shares are listed and traded on the stock exchange, options too are listed and traded at the stock exchange.

Since there are many stocks and indices; many prices points; and many contract expiry dates, there are hundreds of Put Option contracts to choose from.

(Not going into the jargon and all the mumbo jumbo about the F&O market), in the present market conditions you may buy
a. A Put Option on Nifty
b. At an index value of 10500
c. With Expiry Date as 27 Dec 2018 

In this regards, following are the noteworthy points.

1. As we have to protect a complete market portfolio, and not some few odd stocks, buying a put option on Nifty is suggested. Moreover, Nifty index has comparatively better trading volumes. So both pricing and liquidity are good.

2. Currently, Nifty is trading at around 11000. So buying a Nifty Put Option of around 500 points below the current levels, would work well as a hedging mechanism. Hence, you can consider Put Option for Strike Price of 10500. [By the way, these are known as out-of-money put options.]

3. You have to buy a long term protection of at least a year. Besides, further the contract expiry date, lower is the effective cost of buying an option. Also, as many portfolio managers hedge their portfolio on a calendar-year basis, options with  December Expiry are relatively more liquid. If required, after one year you can again buy another Put Option to extend your protection.  [By the way, stock exchanges have fixed last Thursday of every month as the options expiry or settlement date... hence the date Dec 27, 2018.]

This will cost you around Rs.250 per unit of Nifty.

Nifty Options are traded in the lot of 75 units / lot. If you buy one lot, your trade value would be Rs.7.87 lakhs (=75 * 10500). Thus almost 80% of your portfolio, valued at Rs.10 lakhs, would be insured. 

If you desire 100% protection, you will have to buy two lots i.e. 150 units. (Yes, you will be over-protected at 150 * 10500 i.e. Rs.15.75 lakhs. But you can't do much about this, because option trading happens in lots.)

Now let's see how Put Options hedge your portfolio  against steep market corrections  at a nominal cost.

When the market falls, the price of Put Option increases. Therefore, on one hand you make a loss on your equity portfolio. On the other hand, you make a profit on your Options. This may either reduce your loss or even a generate a profit on totality basis. This is summarized in the tables below (for 1 lot and 2 lots).

put-option-portfolio-hedging
Portfolio Hedging Through Put Options (For 1 lot or 75 units)

put-option-portfolio-hedging
Portfolio Hedging Through Put Options (For 2 lots or 150 units)

For one lot, your cost is Rs.18,750 for around 11 months of protection till Dec 2018. This works out to about 2.05% of your portfolio value of Rs.10 lakhs. For two lots, the cost works to Rs.37,500 i.e. 4.09%.

Thus, by paying a nominal cost, you can insure or hedge your equity portfolio against any sharp depreciation in the stock markets.

Hence, buying Put Option is exactly like paying premium for say your car or health insurance.

If, contrary to expectations, the markets go up you still make profits. But the same are marginally lower — by 2.05% (or 4.09%) — which is the cost you paid for buying the Put Option.

All in all, it's a great deal to counter the uncertainty of the stock markets.

IMPORTANT FOOTNOTE
You have to buy this insurance, in the form of Put Option, only when there is a real threat or risk of steep market falls; or you don't have the ability to withstand high volatility. At low valuations, sharp falls are rare. So you may not need such insurance. Or, if you have no requirements say for 5-7 years, you can ride through the volatile periods. Again, you may not need such insurance.

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