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Investors often have insurance for their house, car, life and business, but many don't have insurance for their stock investments and that is a real shame. One way to insure stock investments is by purchasing put options. An investor can insure an individual stock or a portfolio of stocks using put options. In the blog article, “Individual Insurance or Group Insurance Better?”, we examined the relative costs and trade-offs for insuring each individual stock versus insuring a portfolio of stocks using index put options. The basic gist of the article is that it costs less to insure a diversified portfolio of stocks with index put options than it costs to insure each position individually.
Insurance With VIX Options
It is also possible to insure a diversified portfolio of stocks with the Chicago Board Options Exchange Volatility Index ($VIX) call options. The VIX is a weighted blend of prices for a range of options for the S&P 500 index. When the market starts to drop, the VIX moves in a counter direction, so purchasing VIX call options can be used for portfolio insurance. The counter movement of the VIX versus the S&P 500 index ($SPX) is illustrated in the chart shown below:
As shown in the graph, at each instance of a drop in price for the SPX (see red oval areas), the VIX countered with a spike upward. A purchaser of VIX call options could see a significant increase in the value of the options during a market downtrend, so VIX call options can be used to hedge or insure a portfolio of stocks.
Option Insurance Analysis
We analyzed insuring a portfolio of stocks over the time period from 2007 to May of 2010 using PowerShares ETF (QQQ) put options, SPDR S&P500 (SPY) put options and VIX call options. For this analysis, we selected an option with an expiration of one month out for QQQ, SPY and VIX on the Monday following options expiration and with an option value close to $0.50. In the analysis, we assumed one contract of an option would cost 0.5% of a portfolio for insuring the portfolio. For example, a portfolio of $10,000 would require one contract with an option price of $0.50, which would require $50 to purchase the option (not including brokerage fees and commissions). The results of the analysis are shown in the table below:
| Stock Option Insurance Profit/Loss |
| Purchasing Option One Month Out & Closest to $0.50 on Monday After Expiration |
| || QQQ Put || SPY Put || VIX Call |
| 2007 ||+3.7%||+6.3%||-2.0%|
| 2008 ||+2.4%||+5.1%||+18.0%|
| 2009 ||-5.8%||-6.1%||-6.5%|
| 2010* ||+1.2%||+0.8%||+5.5%|
|Total ||+1.5% || +6.1% || +15% |
|*Partial - through May 2010 |
As shown in the table above, the SPY put options performed best in the year 2007 with a +6.3% return and the VIX call options performed the poorest with a loss of -2.0%. So for a portfolio of $10,000, the SPY put options would have generated a profit of $630, whereas the VIX call options would have experienced a loss or a cost of $200.
However, in 2008 which was a terrible year for the stock market with the financial crisis and the bankruptcy of Lehman Brothers, the VIX call options performed the best with a +18.0% return versus a +5.1% return for the SPY put options. For a portfolio of $10,000, the SPY put options would have returned $510, but the VIX call options would have returned a much greater profit of $1,800.
In 2009, the stock market had a banner year and each insurance method, QQQ, SPY and VIX, resulted in a loss (or cost) of around -6%. So for a portfolio of $10,000 the insurance would have cost $600, which makes sense as we are using 0.5% of the portfolio each month to purchase stock insurance (0.5%*12=6%).
2010 and the Flash Crash
In the first half of 2010, the stock market experienced the "Flash Crash", where the market sustained a very large loss and recovery in a matter of a just a few minutes. Each of the insurance methods had a positive return, however, the VIX call options had a very nice +5.5% return versus +1.2% and +0.8% for the QQQ put options and SPY put options, respectively. For a portfolio of stocks worth $10,000, the VIX call options would have returned $550.
The real benefit of using VIX call options for portfolio insurance is exhibited over the years from 2007 to May of 2010 with a total return of +15% versus returns of +1.5% and +6.1% for the QQQ and SPY put options, respectively. Insuring a portfolio of $10,000 with VIX call options would have returned $1,500.
QQQ + VIX Call Options
We wanted to show the combined result of insuring a portfolio of stocks using VIX call options, so we selected the QQQ ETF as a proxy for a portfolio of stocks. We analyzed the result of insuring the QQQ ETF with VIX call options over the time period of 2007 to May of 2010 with the results shown in the table below:
| Profit/Loss of QQQ + VIX Stock Option Insurance|
| || QQQ|| VIX Call|| QQQ+VIX Call|
|*Partial - through May 2010|
QQQ + VIX Call Options Analysis
As shown in the table above, the QQQ ETF returned +3.8% in 2007, but the VIX call options returned -2.0%, so the resulting return was +1.8%. In 2008 with the financial crises and the bankruptcy of Lehman Brothers, the QQQ ETF lost -33.4% which was offset by the +18.0% gain of the VIX call options resulting in loss of -15.4%. In 2009, the QQQ ETF returned +64.0% and the VIX call options had a loss of -6.5% which resulted in a combined profit of +57.5%. And for the partial year of 2010, the QQQ ETF was down -0.8% and the VIX call options returned +5.5%, which resulted in a profit of +4.7%.
2007 to May 2010
Overall for the 2007 to May 2010 time frame, the QQQ ETF returned +2.6% (note: the +2.6% is not the sum of the returns for the prior years, but rather the actual return of purchasing QQQ in January of 2007 and its value as of May of 2010). The net return for the VIX calls over the 2007 to May 2010 time frame was +15.0% and the combined return of the QQQ ETF and the VIX call options was +17.6%.
An investor purchasing the QQQ ETF in January of 2007 would have experienced a measly +2.6% return as of May of 2010, and would have suffered through a terrible loss in 2008 of -33.4%. However, an investor purchasing the QQQ ETF in January of 2007 and also insuring with VIX call options would have a cumulative return of +17.6% and would have only had to experience a loss of -15.4% in 2008. Insuring the QQQ ETF with VIX call options from 2007 to May of 2010 not only significantly increased the return, but also softened the nasty market downturn of 2008.
VIX & European Style Options
The options for the VIX are European style options, which means they can only be exercised on the options expiration date and can’t be exercised early as in the case of American style options. The VIX is also a mean reverting index with the average value of the VIX around 19. So if the value of the VIX is greater than 19, then there is a greater chance of it falling than continuing to rise, and vice-versa. The combination of European style options and the mean reversion nature of the VIX results in option prices having values which are counter intuitive for the VIX. For example, on May 7, 2010 the value of the VIX closed at $40.95 and the value of the May call option with a strike of $30 was at a price around $6. For a normal in-the-money call option (not mean reverting like the VIX), the intrinsic value of the call option would be the difference between the underlying and the call option strike price, which in this case would be $10.95 ($40.95-$30). So the price of the May call option with strike of $30 should have been at least $10.95 based on the conventional wisdom for option pricing, much higher than the actual price of $6. The VIX options can still be bought and sold, but the price received may be significantly different from what is normally expected. Incidentally, the price of the VIX settled at 34.53 for May 2010 and the price of the VIX May 30 call option would have received $4.53 after exercise, not too far from the $6 price on May 7, 2010.
Based on our study, we have decided to introduce the PowerOptionsApplied "Safety Net". Each month we will publish a VIX call option trade for our customers to insure their portfolios. Safety Net may help offset a loss when the market decides to take a tumble. There's no additional charge for the Safety Net, as it is included as an add-on for all of PowerOptionsApplied's TradeFolios. Customers may also find the Safety Net useful for insuring a portfolio of long positions in stocks. In general, customers could use 0.5% of their portfolio every month as insurance. A portfolio of $100,000 could be insured for $500 per month. Unlike auto and home insurance, the VIX call insurance provided by the Safety Net can actually return a profit over the cost of the insurance. The Safety Net is more similar to life insurance, except the person gets to enjoy the benefits of an insurance distribution instead of the beneficiaries.
AutoTrade the Safety Net
Any customer of PowerOptionsApplied may opt to have the Safety Net automatically traded in their accounts using AutoTrade with select brokers. For example, a customer desiring to insure a portfolio of $100,000 using 0.5% of the portfolio per month could opt to enter $500 as the Trade Amount with the trading parameter set to Specific Dollar Amount (calculated as $100,000*0.5%). Every month we will post a new trade to the Safety Net and the broker will purchase VIX call options for the account. For the $100,000 account example using 0.5% per month, the broker would purchase up to $500 of VIX calls each month as portfolio insurance for the account.
The stock market has been extremely volatile over the last ten years, i.e. the dot.com bubble, 9/11, housing bubble, financial crisis and the flash crash of 2010, for example. We hope our customers will take advantage of the Safety Net for taking some of the “bumpiness” out of the stock market and maybe sleep better at night.