28 April 2025
What would it be worth to you to be sure that your portfolio couldn't lose more than 10% this year? That's what buying a put option could do for you, and at little cost.
Because people think that buying options is a most complicated subject, we are going to start complicated, in the introduction below!
But all the terms and ideas used will be unpacked in the following few paragraphs, and at the end, for anyone who gets to the end, there is a lively discussion.
The discussion recaps all that has been explained, and the reader will realise that actually this is a sensible, practical and pretty easy-to-understand subject.
First, the Contents...
Using Strike Puts as Portfolio Protection
Contents
1. Introduction
2. What is a Put Option?
3. How Buying a Put Protects Your Portfolio
4. Understanding the Cost of a Put
5. The Role of Volatility (VIX)
6. A Worked Example
7. Advantages of Using Strike Puts
8. Disadvantages to Consider
9. UK Platforms offering options trading
10. Conclusion
11. NOTE on the VIX
12. Listen to a lively discussion…
13. Glossary
1. Introduction
When markets are rising steadily, it is easy to forget about risk. Yet experienced investors know that protecting a portfolio is just as important as growing it.
One simple tool for this is the strike put - a basic form of portfolio insurance.
The key is to apply it before panic sets in, ie at times of low volatility (as can be measured by the VIX).
Buying out-of-the-money (OTM) put options is a core hedging idea
This strategy, associated with Mark Spitzagel, involves paying a regular cost (negative carry) for the potential of a huge payout ("bang for the buck") if a major market crash occurs.
OTM put options can provide significant returns (e.g., 10x or even 70x return on the cost of the put) during sharp market declines, covering a substantial portion of portfolio losses even with a small allocation (e.g., 1 or 2% of portfolio value).
Risk Tolerance and Strike Selection: A fairly conservative investor might prefer ITM or ATM options, while a trader with a high risk tolerance might prefer OTM options for their potential for higher percentage gains ("Options Basics"). The goal at a minimum is protection against major crashes, not just small dips as in the worked example below.
This insurance is most cost-effective when volatility is low and options are cheap, ideally purchased when nobody else is thinking about hedging. The strategy requires a regular cost (e.g., 1-2% of portfolio yearly) as the options often expire worthless, but this is the planned cost of the insurance. It requires effort, knowledge, patience, and the ability to accept this negative carry. The goal is protection against massive crashes, not small dips.
2. What is a Put Option?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying security at a certain price — this price is called the strike price.
Options must also be exercised by a specific expiration date.
Options are derivative investments, since they derive their value from the underlying assets. They can be bought and sold on an exchange, just like the underlying assets they’re associated with.
A put option gives the buyer the right (but not the obligation) to sell an asset at a fixed price, ie the strike price, within a specified time.
It is like buying an insurance policy: if your asset falls below the strike price, you have the right to sell it at that protected level.
3. How Buying a Put Protects Your Portfolio
If you own a stock portfolio worth £100,000, you could buy put options on a broad market index (like the FTSE 100 or S&P 500).
This guarantees you the ability to sell at the strike price, even if the market crashes.
You effectively lock in a minimum portfolio value for the cost of the option premium.
4. Understanding the Cost of a Put
The premium is the price you pay for the insurance. Several factors influence this premium:
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How far "out of the money" the strike price is (e.g., 1% below current value costs more than 10% below)
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How much time is left until the option expires
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Current market volatility
A 1% out-of-the-money put is relatively close to the current market level, so it offers strong protection.
Suppose you hold a £100,000 portfolio of SPY shares, on which you wish to buy a put. SPY is at 610. You want protection if it falls 1% or more. That protection costs $13 per share.
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You buy a 1% OTM put at a cost of £2,130.09 when the VIX is low, say below 20.
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Strike level: 99% of today’s market level.
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Market falls 20%.
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Your portfolio value without protection: $80,000.
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With the put option exercised, you can sell at 99% of original value, losing only the premium.
Scenario B:
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Market stays flat or goes up.
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You lose the $2,130.09 premium but retain your full portfolio value.
Scenario C:
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Say, instead, you bought the same put but when the VIX was high eg above 40 or 50 - and it cost you $35 a share = $5,737.55
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Protection is still there, but at a much higher cost.
Preparation costs much less than buying insurance in a last-minute panic.
5. The Role of Volatility (VIX)
The VIX Index measures expected future volatility in the market.
When the VIX is low, option premiums are cheap.
When the VIX is high, premiums become expensive.
The best time to buy protection is when volatility is low - not during a crash when risks and volatility are high, and everyone is rushing to buy insurance.
Buying puts when the VIX is calm preserves your purchasing power.
Likewise, selling the puts or taking profits when volatility spikes can sometimes be a smart tactic, even before a full market fall. You can sell anytime up to the expiration date.
6. A Worked Example
Here is an example break down to show an actual cost:
| Event Date | SPY Level | Strike Level | Put Cost (USD) | VIX Level (Approx.) | Percentage Cost (Put/Strike price) | Outcome |
|---|---|---|---|---|---|---|
| Late January | 610 | 600 (1%) | 13 | Low (VIX around 15-17) | 2.17% (13/600) | Bought put protection cheaply |
| Mid-February | 610 | 600 | 16 | Still low (VIX slightly up) | 2.67% | Put cheaper temporarily |
| April 8 | 497 | 492 (June 30 expiry) | 30 | High (VIX above 40) | 6.04% | Insurance much more expensive |
| April 8 (shorter expiry) | 497 | 492 (April 25 expiry) | 20 | High (VIX above 40) | 4.02% | 2.5 weeks protection expensive |
Notes:
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The return on the initial $13 on the Jan put was approximately 8× (put rose to $108) when SPY fell 18%.
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At low VIX, six-month protection cost about 2% of portfolio value ($2,130.09 / $100,000)
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At high VIX, two-month protection cost about 6%.
7. Advantages of Using Strike Puts
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Defined maximum loss — you know the worst case, you can stay in the market regardless.
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Psychological benefit — easier to hold positions calmly....and sleep at night.
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Flexibility — you can profit from volatility spikes even if the market does not crash.
8. Disadvantages to Consider
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Premium cost reduces returns if no crash occurs.
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Timing matters — mistimed purchases can waste money.
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False sense of security if not properly sized against actual portfolio risks.
Cost / potential benefit of buying a put option on SPY in Feb, when the VIX, was low and selling on an 18% correction - 7-fold return
9. UK Platforms offering options trading:
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IG, Saxo, DEGIRO offer access to options markets.
IG have two options offerings: CFD or spread bet account or options via their US Options and Futures account. Here is the link to the US Options and Futures account: US-listed Options and Futures Account – Trade On Exchange - IG UK
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Most UK "investment platforms" (e.g., HL, II, AJ Bell) do not offer listed options trading.
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Trading212 focuses only on stocks and CFDs — no options.
10. Conclusion
Using strike puts to protect a portfolio is simple in theory but demands discipline in practice.
The insurance must be bought ahead of events and when volatility is low.
If managed properly, it can be a valuable tool for preserving capital without sacrificing upside potential.
11. NOTE on the VIX
The VIX measures market expectations of future volatility, not past market movements.
It is calculated by looking at prices of both put and call options on the S&P 500, typically with maturities between 3 to 5 weeks ahead, and across various out-of-the-money levels.
The VIX reflects what the market expects regarding future movement in the S&P 500.
For retail investors, trading options directly on the S&P 500 or its ETF (SPY) is often cheaper and simpler than trading the VIX.
Buying options on the VIX involves complexities because:
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You are trading options on futures, not directly on an equity index.
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Futures-based options introduce additional technical factors.
Since the VIX is already derived from S&P 500 options, betting directly on the S&P 500 provides more direct exposure.
Therefore, it is often more practical to hedge by using SPY options rather than VIX.
12. Listen to a lively discussion
Aimed at enlightening the beginner investor wanting to protect their portfolio in these crazy times:
13. Glossary:
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Put Option:
A financial contract giving the holder the right (but not the obligation) to sell an asset at a specified price (the strike price) within a set time period. -
Strike Price:
The price at which the holder of a put option can sell the underlying asset. -
Premium:
The price paid to purchase an option. It is a non-refundable cost. -
Out-of-the-Money (OTM):
An option where the strike price is below (for a put) the current market price of the underlying asset. -
S&P 500:
A stock market index that measures the performance of 500 large companies listed on stock exchanges in the United States. -
SPY ETF:
An exchange-traded fund that tracks the performance of the S&P 500 index. -
VIX:
The Volatility Index, often called the "fear gauge," measures market expectations of future volatility based on S&P 500 options. -
Volatility:
Measures how widely values are spread around the mean. The square root of the average of the squares of the deviations from the mean, aka the standard deviation. Note that... -
Variance:
is the sum of deviations from the mean, and standard deviation is the square root of variance. If you wonder why all this squaring, it is just to obliterate the difference between +deviations and -ve deviations. -
Implied Volatility:
Looks forward in time. The market's forecast of a likely movement in a security's price, reflected in the price of options. -
Market Makers:
Firms or individuals who provide liquidity by standing ready to buy and sell securities or options at publicly quoted prices. -
Hedge:
A financial strategy used to reduce the risk of adverse price movements in an asset, often by using options. -
Portfolio Insurance:
Techniques such as buying put options to limit potential losses in an investment portfolio. -
Liquidity:
The ability to buy or sell an asset or security quickly without causing a significant movement in its price. -
Annualised Cost:
The cost of a financial product or protection expressed on a yearly basis, often used to compare short-term and long-term costs. -
Roll (Options):
Closing an existing option position and opening a new one with a later expiry or different strike price, typically to extend protection or lock in profits. -
Spread (in options):
The difference between the bid and ask prices for an option. A tighter spread usually means better liquidity. -
Market Panic:
A period when investors rush to sell assets due to fear, causing sharp falls in asset prices and spikes in volatility. -
Index:
A statistical measure of changes in a portfolio of stocks representing a portion of the overall market.
[End]
