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Yes, You Can Buy Insurance Against Plunges In Stock Prices

Issues

An insurance policy is a contract between two parties whereby the issuer, or underwriter, of the policy is obligated to pay a pre-specified amount to the holder, or buyer, if something "bad" happens. In essence insurance protects you when bad things happen. I am sure you are familiar with car, earthquake, medical insurance and so on.

So with the Dow Jones falling more than 500 within a few weeks, why not have insurance to protect yourself against further market plunges?

Analysis

You can actually buy such insurance. It is called "portfolio insurance."

Just like your car insurance, the premium that you have to pay depends on the amount of coverage. The larger the amount, the more the premium. When buying "portfolio insurance," one of the important variables determining the premium is the volatility of stock prices, i.e., the range of stock price swings. The wilder the swings, the more the premium.

On March 31, the Chicago Board Options Exchange's measure of volatility hit a high of 30%, the highest in at least four years (WSJ, April 1, 1997). To insure a portfolio consisting of the S&P 500 stock index against any decline in the next three months would cost $3.80 per $100 protected, compared with $2.62 last October and $2.67 last March. This translates to an annualized cost of more than 15% of your portfolio, according to the Journal.

In technical terms, the insurance is a "put option" on the value of the asset you are trying to protect.

In general, an option is a contract that gives the holder the right. but not the obligation, to take a certain action for a certain period of time. A stock option gives the holder the right, but not the obligation, to buy or sell stocks at a particular price for a certain period of time. The simplest form of portfolio insurance is a put (an option to sell). An investor can pay a premium for a put option and, without having to sell stocks, protect a portfolio against a drop in the stock market below a certain level.

 

By Alex Tajirian


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