Wednesday, 21 December 2011

Buy insurance for your portfolio

This is that time of the year when most salaried employees start thinking about tax saving and inevitably one of the first things that people think of is insurance. It is probably our conditioning that we buy LIC (and these days from private insurers) policies without blinking much of an eyelid. 
What exactly is a life insurance policy? It is nothing but a put option on your earning power. Basically, it protects your family from the loss of your earnings if and when you are no longer there. Simple.


However, a lot of stock investors do not think of buying similar "insurance" policies for their portfolios. I call these stock insurance policies "catastrophe insurance". No, they are not sold by LIC or other such insurance companies. They are traded on stock exchange in the form of PUT and CALL options. 


One way of buying such an insurance is to buy out-of-the-money PUT options of the index for a long duration. For example, if you buy a 4000 or 3900 PUT option for the month of February or March now, you are sort of covering a part of your losses in case the markets tanks. This typically makes sense for people who have very large equity portfolios. You pay a low/moderate premium to get some peace of mind. The way the markets are poised right now, I think it would be a prudent thing to do.

2 comments:

  1. I hope the situation improves, but the tragedy of the Indian options market is it is not too liquid except for the current month (or maybe the next month only when we are close to expiry of the current month). Look at the buy-sell spread for the Feb/March put option. For a large portfolio, not too sure how you can accumulate insurance with that kind of liquidity.

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  2. You are right. But the idea for portfolio insurance is to buy the options cheap and the current month ones are rarely so. The idea is not to get in to make a killing on the option itself, but to get some money back if the market tanks a lot from this point.

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