Protect yourself from a Market Crash

Asad Dossani
-13%: The largest daily drop in the value of the Nifty Index since 2007. This occurred on 24th October 2008, right as the global financial crisis took hold.

Markets crash. This has always been the case and always will be. And while we know that the market will crash at some point, we don't know when this will occur. Nor do we know how large the crash will be. But we can still do something about it.

We're going to talk about an options trading strategy called the protective put. A protective put is used to insure ourselves against market crashes. It is a trading strategy that makes money when the markets crash, and loses money when the markets go up.

Now imagine you own a stock portfolio. And suppose it's a long term portfolio. That is, you intend to hold these stocks for the long term, and you expect to make money doing so. But in the short term, markets fluctuate. You can easily lose money in the near future for all kinds of reasons.

For example, there could be another global crisis on the horizon. Or we could have an economic slowdown.

Some of us may be happy to take these risks and ride out any storm that comes. But not everyone. We may actually prefer to insure ourselves against market crashes. Even if it means paying a little extra when markets are strong, it is worthwhile if markets crash. We can do just this using a strategy called the protective put.

Here is how it works: Again, suppose you own a portfolio of stocks in the Nifty index, or you own the Nifty index itself via an ETF. A protective put strategy buys an out of the money put option on the Nifty index.

A put option gives the holder the right to sell the underlying asset at a particular price on a particular date. Suppose the current value of the Nifty is 8,000. And suppose we buy a 3 month put option on the Nifty index with a strike of 7,800.

At the end of three months, if the Nifty is above 7,800, the option expires worthless. If the Nifty is below 7,800, the option gives us the difference between 7,800 and the value of the Nifty. Suppose the Nifty closes as 7,700 after three months. Then the option has a payoff of 100.

Why is this an attractive strategy? Well, it makes money if there is a large fall in the markets. If the markets do not fall much or rise, then we lose the initial premium paid for the option.

The good news is that because it is an out of the money put option, the premium will be small. And more often than not, the Nifty won't crash. But on the occasion that it does crash, we get a large payoff.

And this is biggest attraction of the protective put. It puts a cap on how much we can lose in the stock market. If we own a stock portfolio, and that portfolio falls in value during a market crash, the protective put's profit will offset the fall in the value of our portfolio.

It is best to think of the protective put as an insurance policy. We pay a small premium to protect our portfolio. In the event of a market crash, our portfolio losses are capped.

There are two ways we can use the protective put. One method is to regularly buy out of the money put options. This would keep you always insured against a crash. The motivation for doing this is to reduce risk, not necessarily to increase returns.

The second method is to only buy a protective put only if we expect markets to crash. In this case, it is more speculation rather than insurance, but can possibly increase returns.

A protective put can be used to insure against the market index or a single stock. It is a versatile strategy, and one worth considering for your portfolio.

Are you interested in using protective puts or other option trading strategies for your portfolio? Share your views in the Club or share your comments here.

P.S. Want to learn more about option trading strategies? The check out our e-learning course DeriVantage, filled with everything you need to know about derivatives and options.

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4 Responses to "Protect yourself from a Market Crash"
28 Sep, 2014
Dear Sir, Like the Punch-Line of the article " Reduce risk rather then increase in Returns" ThanksLike 
N.S. Sreeraman
27 Sep, 2014
27th September 2014 I am a Government employee, having interest in equity based business. In the earlier years, I used to apply for shares whenever a somewhat good Company comes with its IPO. But, may be that, I may not be that much lucky enough to have any one of them, except a Convertible Debenture of a somewhat famous Company. I kept those Debentures for quite some time, say, approximately about 11 months. But, the price of Debenture was not going upwards, rather, it started declining. Then I decided to sell the same for a little lesser loss. Thereafter, due various reasons, and due to official work, I could not devote time to proceed any further. But during the beginning of this year, I again thought of entering into the market. It was at that time, one of a large Share Trading Company contacted me. Though time was a very crucial factor, and as they assured me that they will handle the business without causing any loss to me, I agreed and the trading started. One day, I asked them to purchase some Shares of a particular Company (name I am not disclosing) for a particular amount and asked them to keep it. But, within two days when the price has come down to the extent of Rs.3/-, they disposed of the same, which caused a little loss to me. Next time, after informing me, they purchased Shares of a Bank and even though I had asked them not to dispose of the same, on the fourth day, despite my instruction, those Shares were also sold out causing me a more loss. Thereafter, my wife started quarreling with me because of the considerable loss caused and to stop the trading business. Then, I also thought that she might be right as the money is being lost and therefore, I stopped it. Now, I am quite afraid of thinking about it. It is quite interesting to note that the aforesaid Shares which were sold out, are now standing on a very high pedestal, say about five times! If the Trading Company would have stuck to their promise, I could have earned a considerable amount of profit, if those Shares were sold out at present. Whatever it may be, my entire enthusiasm in trading has disappeared, rather, I am quite afraid of entering into the field again! I would like to know your opinion in this behalf as to whether I have to pay any amount for keeping the Shares by the Trading Company quite for some time? Was that the reason, they have sold out the Shares? Now, if I again start doing the business, would it be feasible? You may be aware that, being a Government employee, I am not a person having huge amount to invest. I am doing it only with my limited income. Therefore, I do not want to take further risk any more. What is your view? Kindly enlighten me on this aspect, only in my email. My wife and hold a joint SB Account. Suppose I purchase the Shares in my wife's name, and if any profit is gained after selling the same, would that amount be treated as income of mine while calculating the Income Tax? Please impart necessary advice for which, I will ever be grateful. Thanks. N.S.Sreeraman.Like 
Manoj Tewary
26 Sep, 2014
Suppose I hold Nifty ETF portfolio of value 10 lacs. Currently what Put should we buy, how much & how you arrive at the decision? Further can we finance this by selling Calls, if that is a profitable & effective strategy, then how to execute the same. The same issues what call & how much to sell. Warm Regards, Manoj TewaryLike 
26 Sep, 2014
Dear Asad, What is the time frame you are talking about to buy a protective put ? Even if the fundementals do not justify any increase in prices, We have often witnessed a bull run based only on optimism and collusion of a few big broking houses to creat the illusion that everything is rosy. In such a scenario, especially when FIIs are pumping more money in our stock markets,the markets will continue to rise on a sustained basis. Any correction will be caused only on profit taking. We will continue to pay the premium and will be incurring a cost. Please correct me if my views are wrong.Like 
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