> E.g. If I am net long in my portfolio and I fear some headwinds I can buy a put or two for the peace of mind. Now those puts should be always considered as worthless, and it is just the price to pay for the peace of mind.
Why don't you just change your allocation?
If you can't sleep at night because of your current portfolio, and gyrations that are occurring, or that you are worried could occur, I would say it's obvious that it's not suited towards your risk profile.
You're burning up some of the potential upside by spending money on the options, so why not simply take some money off the table instead and have a less complicated setup?
Year ago when we were reading the news about what is happening in Wuhan, some of my friends bought SPY puts as an insurance against the potential crisis.
The best outcome for them would be if those puts expired worthless. When you insure your house, you don't usually wish for it to burn down.
I haven't acted and my portfolio took a -30% hit right after.
Your suggestion (to change the portfolio allocation) would mean temporarily selling stocks and holding money. That strategy has an unlimited loss potential[0] if the stocks rise before you buy them back. With puts you are limited to whatever you pay for them.
edit:
[0] unlimited loss potential provided you want to keep the same stake at the companies
Rebalancing is a thing, though generally for risk reasons. It would/could have saved one's returns during the so-called Lost Decade of the 2000s with the S&P 500:
As your equities dropped, there's a good chance bonds would have at least stayed neutral, or even risen: so you'd sell some of those (sell high) and pick up equities at a discount (buy low).
There are even products available that do this automatically for you:
>When you insure your house, you don't usually wish for it to burn down.
You're leaving crucial information. You don't buy insurance (or puts) at any price. It has to make economic sense, and the person on the other side presumably has the same information.
Of course, being safer (more conservative) brings lower profits. I'm for sure not suggesting to be puts-insured all the time! It is just a useful instrument when one wants to hedge.
The person on the other side is likely a market maker selling both kinds of options. The price is dictated by market.
It's unlimited opportunity loss. If you sell at say $100 and it goes to $1000 while you're in cash, you "lost" $900 vs your original position. However if you hold at $100 and buy a put for $2 that hedges you, you can still participate in the upside while limiting your downside. Also, downside risk has been historically undervalued (this may be changing though) which is why tail risk funds exist.
everything has an unlimited opportunity loss though. if I put all my money in SPY, I'm forgoing the "opportunity" to buy a bunch of OTM gamestop calls at the perfect time and 10x my net worth.
The strategy forces you to time the market. You might get unlucky by holding cash during a market rally, then buy back for a dump.
An investor who sells when they think the market is going to go downhill, with the intention to buy back later is not acting as an investor but as a trader.
That's why hedging with options is less risky (and less profitable in the best case).
edit: My use of word 'unlimited' applies if you want to keep the same stake at the companies. In money terms you cannot lose more than the value of your holdings.
Yep, then I agree. I'm not advocating for trying to time the market, or holding cash instead of being on the market.
But selling your position simply does NOT mean you take on "unlimited loss potential". It's simply being outside of the market, which means you're missing out on gains. It's not like selling stock is suddenly the same as shorting the same stock. I think the terminology here is clear-cut and well established.
I get what you're saying and I think your terminology makes sense.
But the way to understand this is to reframe your view of "money" from being some special, neutral thing to just being another asset.
At any given moment, you could own $1000, or some gold, or some bitcoin, or whatever else. There is nothing special about the fact that it's $ you're holding rather than DOGE or SPY.
So imagine a 2-asset world, that has SPY and $ in it. You are holding $1000 right now, and the market goes from 1 SPY = $1 to 1 SPY = $1000. That is a loss. Denominated in SPY, you just lost 999 SPY.
It’s unlimited because in the time he is holding cash there’s no limit to the amount the stock market could increase. If he sells a stock for $10, and then it goes from $10 to $10,000 he’ll only be able to buy back 1/1,000th of what he had. He lost $9,990.
It’s the same as writing call options. There’s defined upside and unlimited downside.
> How does holding money have an "unlimited loss potential"? You just buy back at whatever value the stock is at the time.
It does not have unlimited loss potential, I'm not sure why the poster said it did. It's the opposite - holding has unlimited upside potential(however slim).
People don’t realize you have unlimited loss potential on every stock you are not holding right now, and that’s why cash is not a great position. When you sell and wait for a dip, you are basically in a short position except you’re not borrowing stock.
I had SPY puts expiring in April at the same time, but as a hedge against Bernie Sanders doing unexpectedly well on Super Tuesday. He didn’t, but my timing was still good against a factor that I had been entirely ignoring.
Why don't you just change your allocation?
If you can't sleep at night because of your current portfolio, and gyrations that are occurring, or that you are worried could occur, I would say it's obvious that it's not suited towards your risk profile.
You're burning up some of the potential upside by spending money on the options, so why not simply take some money off the table instead and have a less complicated setup?