This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.

Why Investors Should Insure Their Financial Assets

CME Group

Contributor:
CME Group
Visit: CME Group

At A Glance

  • Events like the trade war or Fed policy changes can present risk to active trader portfolios
  • Options on futures can act as a hedge against major drops in the market

The entire insurance industry is built around the need for the protection of assets. Most people view things like their car, home or belongings in their apartment as assets to be protected.

Auto insurance, homeowner’s insurance and renter’s insurance are all products we buy without hesitation to protect the value of those assets if disaster strikes. But shouldn’t most people also view their investment or trading portfolio as an asset to be protected?

Portfolio Insurance

A financial portfolio is certainly an item of value, and like with other assets, the risk of disaster means some type of insurance should be considered. The best example of portfolio insurance (in my view) can be found in equity futures and options traded at CME Group.

A portfolio consisting of multiple individual stock holdings, ETFs or indexes generally represents long-only positions. These positions are accumulated with the idea that the value of the overall portfolio will increase. Typically, over time, that is the case. The S&P 500, however, has fallen more than 10% 42 separate times since 1928, according to a note published by Yardeni Research in 2018.

Twenty of those price drops exceeded 20%. In that same time period, the S&P 500 has lost 48% or more of its value a startling five times! The most recent example is a 56.8% collapse that began in 2007 and hit bottom in 2009.

Surely these types of “disasters” are worthy of insuring against, but the desire for investors and traders to outperform to the upside incorrectly trumps the sensible use of futures and options to insure or “hedge” against downside risk. It is a small example of hope overtaking common sense.

Plenty of Risk

Given the trade war with China, the global economic slowdown, Brexit, domestic political tension, the recent spikes in Repo rates, the recently inverted yield curve and the confusion over U.S. Fed policy on interest rates, the time for portfolio insurance seems to be now.

CME Group not only offers options on the S&P 500, the Dow Jones Industrial Average, the NASDAQ 100 and the Russell 2000, but also Micro-E mini futures on all these indexes, which are one-tenth the size of the E-mini contracts.

The concept that needs to be embraced when hedging a portfolio is the same as when buying auto or homeowner’s insurance. You are paying for protection that you hope you never need. If you buy a put on the Nasdaq-100 or sell some Micro E-mini futures on the Russell 2000, you want to lose that money, because if you do, that means your core portfolio has gained value.

Think Like A Homeowner

It is true that this reduces your portfolio’s overall return but consider this example: if someone buys a home for $350,000 and sells it ten years later for $400,000, they will tell their friends and family that they profited $50,000, or 14.2%, on their home. The reality is that they likely spent close to $10,000 or more over that same 10 years in homeowner’s insurance, so their actual profit was closer to $40,000 or 11.4 percent. They could have theoretically opted to forego disaster insurance, but no one would ever do that, right?

Yet traders and investors do this all the time with their portfolios, when a simple hedge with micros or options on futures can often protect against some of the downside risk. Active investing and trading portfolios are often viewed differently than hard assets like a home or car, and this is wrong.

It may take a little investigating to find the right insurance for a portfolio, but the resources and products are there. Giving up some of the upside potential of a portfolio may not be the first instinct for most traders, but it will feel like good money spent when the next disastrous price drops come.

Originally Posted on December 2, 2019 – Why Investors Should Insure Their Financial Assets

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from CME Group and is being posted with permission from CME Group. The views expressed in this material are solely those of the author and/or CME Group and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: Options Trading

Options involve risk and are not suitable for all investors.

Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options”. For a copy, call 312 542-6901.

Disclosure: Futures Trading

Futures are not suitable for all investors. The amount you may lose may be greater than your initial investment. Before trading futures, please read the CFTC Risk Disclosure. A copy and additional information are available at ibkr.com.

trading top