Portfolio Insurance with a twist

M

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With all the ups and downs in the market it can be painful watching 20-30% gains being wiped out so I was thinking about how to lock in gains and thought about using puts.

Thinking of this as a type of insurance, I looked up portfolio insurance and found that the insurance is usually bought on the entire portfolio and right from the beginning.

The article about it all suggest the logical - i.e. that it reduces losses and volatility but also reduces gains.

But what about only insuring the winners after they reach beyond their average gain?

If you're comparing this strategy to just buy and hold, then what about selling the puts/insurance for a gain after a typical drawdown and reverting back to the original position and reinsuring if it reaches the original high gain?

Would this type of strategy for the portfolio do better than buy and hold on average? I have Wealthlab but it doesn't allow options information so I don't know how this can be tested or if it has before.

Is there a name for this type of portfolio strategy?

Here's an example of what I was thinking:

Portfolio details:
1) Portfolio has 10 funds/stocks worth 10% of the portfolio each.
2) The average gain for each of the fund/stock is 15% / year
3) The average drawdown for each fund/stock is 10-20% / year

Proposed strategy:
1) If a fund gets 25% before the end of a year buy long-term puts on a highly correlated ETF/stock. Buy the puts with 10/25% of the gain leaving you with a 15% gain locked in for the year.
2) If the fund/stock drops 10-20% sell the puts and wait.
3) If the fund/stock doesn't move/goes down, just keep the original position. If the fund/stock goes back up over 25% gain for the year, start over at 1)

Does this make sense?

It doesn't seem like there's much drawback to it but am I missing something?

Thanks in advance,
MPO
 
Suppose:

Stocks which have already gone up may continue to go up, making your puts just an expense.

The stocks which declined in the beginning, which you had no puts on, keep on declining.
 
Quote from DrChaos:

Suppose:

Stocks which have already gone up may continue to go up, making your puts just an expense.

The stocks which declined in the beginning, which you had no puts on, keep on declining.
More...


Right, but that's the worst case scenario.

The question is whether the proposed strategy is better on average than just buy and hold given all scenarios. I'm also curious if it's better than a "universal portfolio" type strategy where you redistribute routinely - which sinks more into the losers and takes away form the winners.

It would be great to see how this backtests but as I said Wealthlab doesn't do options.
 
Quote from Traveler:

Don't you think the likelihood of a 25% decline in the stock is priced into the puts at the time you bought them?
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Not necessarily. For instance, one of the main things that got me thinking about this was my metals fund. At one point it was up over 50% (VGPMX) for the year. Now it's at 28% again (29.5).

While funds don't have options, ETF's do so I was thinking about hedging the position with Dec06 40 puts on GDX. GDX is at 39.73 and the puts are at 3.9.

So let's say I started with 10k in VGPMX and my current value is 12,800 (about 440 shares). I would be willing to give up 5-10% of my 28% gain for insurance, or $500-$1,000. So let's say I buy 2 contracts at 3.9 for 780 (27 shares). And my position is now only worth 12,220 assuming a total loss on the puts.

Now let's say there's a correction of 20% and VGPMX and GDX go down accordingly. So my VGPMX is down to 23.6 and is worth 9747 - so overall it's down 253 from the initial 10k. GDX is now at 31.8 and the intrinsic value of the puts is now 8.2 and they're worth a minimum of 1,640 so the net position is actually
11,387. This compares to it being at 10,384 if I had the full 440 shares. I.e. it would save a full 10% of profit.

If it would go down the full 28% it would be worth 11,050 with the insurance but only 10,000 without - again locking in a greater than 10% gain.

I'm sure there are a bunch of positions and most stocks where the premiums may be to high - but what about for situations like above?

Thanks,
MPO
 
Thanks for the comments. I agree that it's expensive, but I wasn't sure if it was better than rebalancing or not. If a market crashes across the board, then even when you rebalance all of your positions go down but if you have puts or are short opposite positions, you can lock in profit.

That's why I was thinking in terms of puts anways.

The VIX is broad and I was actually thinking of rather haveing a whole portfolio insured, just insuring the parts that are performing higher than expectations.

Selling the position would work as well but then the cash doesn't grow with a drop in the market and wouldn't let you hold the majority of the position for the long term.
 
if your primary goal is to lock gains then selling calls might be more aligned with it in terms of payoff than buying puts - also, riskarb made a suggestion in another portfolio insurance thread to do both, i.e. sell calls and buy puts, which seems like an excellent idea, although i have not yet had the time to investigate what the actual numbers would look like with this strategy. all the best.
 
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