what is Portfolio Insurance?

Question

what is Portfolio insurance strategies?

Answer 1

In the 80's Prof. Leland of UCal Berkeley was having financial problems of his own. He was alos teching. Then he used to worry about some way to get out of it and used to think of the Options route for this. Every night he used to wonder about a safe way to use options to make wealth. One night an idea cropped up in his mind which he thought was failsafe. He thought if the stock prices move up to points from where it can only come down how to book profits without selling them. He thought the best way is selling calls. The prices when come down he would have pocketed the profit. Now he has the premium and the price of the stock is low and he buys more of the stock with it at low prices. Keeping on doing this can incerase the profitability of his investment. Then he contacted his collegues Rubenstein and Obrien and they worked out a method using this to insure the portfolios of large scale investors like Financial Institutions and High Networth investors and they called it Portfolio Insurence and charge them a fee for this. Later on during the Black Monday the stock market melt down this was considered as the culprit behind the melt down. They attributed this to the expiration day effects caused by option traders called the 'triple witching hour' where the options, options on futures and the arbitrage option traders converge to create high volatility of the market. After this regualtory study it was decided to abandon Portfolio Insurence trading as market strategy.

Answer 2

Say you have a portfolio of $100,000 woth of stocks and you are concerned that the market might drop and that you might loose 25% of the value of your holdings. Not an uncommon happening. Let us suppose that the beta of your portfolio is about 1.00. Now you can hedge against a loss in your portfolio value by buying puts on the S&P 500 index, which also has a beta of about 1.00. Now if you want full protection you will buy a dollar value of $100,000 worth of puts. If you want 50% protection you will buy $50,000 worth of puts. They of course will cost you money but if you are wrong and the market goes up instead of down you are out only the cost of the puts minus how ever much the value of your portfolio went up. If the market tanks, he value of your puts increases offsetting the loss in your portfolio.

Some puts have a beta much higher than 1, such as QQQQ. So you do not have to purchase a 1 to 1 relation of QQQQ to cover your potential losses in your portfolio. But since they are more volitile the premium is greater so it is sort of 6 of one and a half dozen of the other.