In a couple of recent Monday Wraps leading into the "go away in May" period, I mentioned that the extremely low implied volatilities made options cheap. I suggested that those traders who were long the market might think about buying a(or more than one) cheap put as Armageddon insurance.
The idea sparked some interest, but what exactly would constitute Armageddon insurance, several subscribers asked. That would depend on one's positions, one's tolerance for risk, and also one's ultimate goal with the positions held. For example, a 35-year-old trader who had gradually built a long portfolio with a buy-and-hold goal might not want to risk a 50 percent loss in that portfolio's worth but might be perfectly comfortable with a 20 percent pullback. A 65-year-old who had lost money in 2000-2002 and again in 2007-2009 and was now going to need to begin pulling out that money within the next few months might not want to lose more than 10 percent.
Imagine that a middle-aged investor with faith in IBM's long-term prospects has accumulated 600 shares of IBM with an average cost basis of $171.00. The following analysis chart shows that investor has, as of May 1 when this article was roughed out, accumulated a $17,220 profit.
Hypothetical IBM Position with Shares Accumulated with an Average Cost Basis of $171.00
Now imagine that middle-aged investor decides that, as much faith as she has in IBM's future, she doesn't want to put more than two-thirds of her $17,220 profit at risk if there is any chance markets are about to cascade uncontrollably lower.
Same Position with 6 OCT13 190 Puts at $3.45 per contract:
Is this Armageddon insurance? Perhaps not, as it's meant to kick in rather soon and protect profits. It's expensive, at $3.45 x 100 multiplier x 6 contracts = $2,070 plus commissions. Some of that cost can be offset by the judicious use of sold calls to help pay for the puts, after consultation with a broker about the pros and cons of selling calls against a position. There may be tax implications, for example, impacting the cost basis of your IBM position.
If it's perhaps not exactly Armageddon insurance in the way I use the term, it still may be an appropriate choice for some investors. Buying put protection to put a floor under the losses that will be experienced is definitely something I want in my own portfolio, and I accept the cost for this decision. I'm sixty-three, my husband a bit older, and our goal is to protect the money we have from big losses while hopefully participating in modest gains.
I think of Armageddon insurance as insurance that protects the investor or trader from catastrophic losses of the kind that might be experienced in a flash crash that doesn't rebound, a 1987-type crash or even our more recent 2007-2009 period. It means something different to each investor or trader. At 63, a catastrophic loss to me might mean more than 30 percent of my portfolio's value. To a twenty-something who intends a long-term buy-and-hold strategy, it might mean more than a 50 percent loss in value. That 20-something has time for the portfolio's value to build again.
Let's look at another position at the other end of the spectrum, a position in which Armageddon insurance might not even be needed or workable, even if desired.
OEX JUN Iron Butterfly, One Contract:
Scanning across the bottom of the expiration profit and loss graph, it's easy to discern that the maximum loss for this position is just a little over $1,000 plus commissions, no matter where prices go. It's possible to buy an Armageddon put for this position, but two facts argue against that tactic. In order not to undercut the potential profit too steeply, that put may be so far out of the money that it does little good unless the markets totally crater. Then you may have bigger problems than this $1,000 loss. The second fact is that the small size of the trade may be all the insurance you need against big losses. In uncertain times, scaling your trades back so that the maximum loss is tolerable may serve as well as buying Armageddon insurance.
I do buy Armageddon insurance. My live position as of May 1, 2013, without commissions, when this article was roughed out, is shown below.
RUT JUN All Put Butterfly:
This was a 10-contract 860/910/960 all-put JUN butterfly with a DITM long 820 call, 2 910/920 call debit spreads and an extra 860 long put as my Armageddon insurance. This Armageddon insurance also serves as volatility insurance because it will inflate in price as implied volatilities rise sharply on a decline. With this insurance, my maximum downside loss is $21,545. Without it, the maximum loss is not much more, at $24,755. However, where this Armageddon put helps me most is not at expiration. It would help me most on a quick jolt down to maybe 870 after the jobs number that was due two days after this picture was snapped, for example. Theoretically, without that Armageddon put, my loss would zoom to $4,601 although it would probably be much higher since the implied volatilities would shoot higher. With the Armageddon put, the theoretical loss would be about $2844, although it would likely be less because that OTM put will inflate fast with a rise in implied volatilities. That $2844 is within my intended maximum loss per contract, at $300 per contract or $3,000 for the entire position.
Of course, we know now that jolt lower never occurred. The non-farm payroll number surprised to the upside and the RUT took off to the upside, too. However, the Armageddon put allows me to stay in a trade in dicey times and know that I'm less likely to wake up some morning with the unrealized losses well past my intended maximum loss. That can and does happen to traders. Plans are all well and good but if a gap and strong run doesn't give you the chance to exit or adjust, plans don't help. At my age, with our financial goals, this is what works for me, although none of my fellow trading group partners believe this tactic is necessary with this particular trade. I make lower profits due to the cost of the Armageddon insurance, but I don't stay awake watching futures all night.
So, what is Armageddon insurance? It's different things to different people. It may be sizing down enough that you can afford to lose everything in a trade. It may be buying a put position that protects profits you've gained. It may be setting up enough put protection that you can exit or adjust before you're beyond your maximum intended loss.