Last week I bought put options on the Dow Jones. They rise in value if the US market declines by a large percentage. I don’t know for sure that the US market and, through contagion, the UK market will fall in the next six months. But given the current stretched US valuations I want to avoid suffering the extreme regret that happens when you get caught up in a major downward market move and all you’ve got in your portfolio is assets that are hunky dory so long as the market is going up.
Those of you who have been reading my Newsletters for a while will be aware that I was concerned about stretched US asset values last July and bought put options back then. The Dow was around 21,000 at the time. These options expired worthless in December. So I had paid an option premium which had been wiped out.
Do I regret doing it? No. That is the way with insurance policies – you pay out and you are quite content if you don’t have to collect. I paid premiums again in December to cover the period up to 21 September 2018. Again, it looks like these will expire will expire worth nothing.
Previous newsletters on the theme of stretched markets and put options: 7th – 27th June 2017, 7th – 8th July 2017, 20th – 21st December 2017.
What I bought last week
I purchased March expiry 185 puts, priced at $0.58 each. These puts give me the right but not the obligation to “sell” the Dow at any time between now and the third Wednesday in March (i.e. 20th) at a price of 185.
You will have spotted that the Dow trades in the thousands – indeed it is over 26,000 – so it seems odd that my strike price is a mere 185.
The explanation is that the convention in this options market is that each real Dow value is divided by 100.
So, 185 in the options world represents a Dow in the real world of 18,500. So effectively I’ve bought the right but not the obligation to sell the Dow at 18,500. My counterparty (really the central organisation for this sort of thing) is obliged to buy at the price of 18,500 (185 in option terms).
So if the Dow fell to say 17,000 in January 2019 I have the right to sell at 18,500 but can buy in the market at 17,000. There is a 1,500 gap.
The gap in option terms is 185 minus 170, i.e. 15 points. To bring the options world and the real Dow onto the same terms the convention is to value each of the option points at $100.
So a 15 option point gain is worth 15 x $100 = $1,500 in real money terms.
By the same token, I did not actually pay a mere $0.58 for each option bought. I paid $0.58 x $100 = $58.
If the Dow falls to 17,000 then my profit is $1,500 – $58 = $1,442. Profit is 25 times what I put down.
If the Dow only falls a little to, say 22,000, then my options expire worthless in March. So they are only profitable in the event of a large market fall (because they are extreme out-of-the-money options). But then, on the other hand, I haven’t suffered much on my UK share portfolio, if at all.
Some other possible outcomes are shown in the table. If stock
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