Buy a cushion when a fall is imminent

MUMBAI: With the Sensex at its current lofty levels of over 10,000 points, the main risk for most stock portfolios is market risk, also known as systematic risk.

A question some investors may have at this point is whether it is possible to buy insurance for their exposure to the stockmarkets. After all, an adverse news development like an unfavourable budget announcement would certainly lead to a substantial price correction.

The good news is that there are several kinds of insurance policies available in the stockmarket. In fact, these policies have been running for some time now - since June 2000, to be precise, when equity derivatives were introduced to the Indian stockmarkets.

Insurance can be bought by investors for their stock portfolios, either by selling futures or buying put options. By selling futures, investors can gain when the market falls, which can offset the loss in their portfolio. The risk of the stock prices falling, therefore, is eliminated.

Let’s consider an investor who owns shares of Infosys because he believes in the long-term growth story of the Indian IT sector; but who now fears a temporary drop in the value of the company because the entire market may fall. He’s not sure, of course, or else he would have sold his shares and re-entered at a later time.

The risk with this strategy is that if Infosys shares rise from the current levels, the investor would incur a loss when he decides to re-enter the stock.

Enter stock futures. The investor can just sell an Infosys futures contract with a 1, 2, or 3 month expiry period (all three choices are available), and be rest assured that he doesn’t lose anything if Infosys’ share price drops. Whatever he loses from a drop in the share price, he would gain in the futures contract.

But then, he would miss out on any gain made by Infosys shares as that would be offset by losses on the futures contract. To tackle this problem, some investors prefer buying put options as a means of getting insurance for their stocks. With put options, you just have to pay a certain premium, which is normally around 1-2% of the contract value. The premium is the maximum an investor would lose from the contract.

On the other hand, if there is a drop in the share price, the losses would be offset by gains in the put option contract.

Let’s take an example. Infosys shares trade at Rs 2,862 currently and investors can buy a put option that would allow them to sell Infosys shares at Rs 2,900 for a premium of Rs 70 per share (2.4% of the contract value). Let’s assume the share price drops to Rs 2,500.

That would mean a loss of Rs 362 (Rs 2,862-Rs 2,500) on the shares, but a gain of Rs 400 on the put option contract (Rs 2,900-Rs 2,500), resulting in a net gain of Rs 38.

Adjusted for the cost of buying the option (Rs 70), the loss would be limited to Rs 32, which is substantially lower than the loss of Rs 362 the investor would have incurred had he not bought the put option. And if Infosys shares gain, the maximum loss the put option buyer would face is Rs 70.

That’s a simplified way of explaining the concept of buying insurance for stocks. But most times, investors have a portfolio of stocks, and it would be cumbersome to buy options or sell futures of all stocks in the portfolio.

At such times, it makes sense to just deal in Nifty contracts, which will help deal with systematic risk. This is because the Nifty represents market movement, and if the market rises or falls, this is captured by the Nifty.

Currently, put options for selling the Nifty at 3,000 (rough equivalent for Sensex at 10,000) are available at Rs 31.1, which is just 1.04% of the contract value.

In other words, for every Rs 1 lakh an investor wants to protect from the risk of the Sensex dropping below the 10,000 levels, he ought to spend Rs 1,040 as insurance premium. Considering that losses could run into tens of thousands, that’s reasonable.