This is a basic, but interesting article on the use of options as insurance for your portfolio. Having read the book: When Genius Failed…The Rise and Fall of Long Term Capital Management (must read), I’m not a big fan of this strategy. I’m not going to go into the details of the book, but suffice to say that the derivative picture it paints is scary. I do not believe that things have gotten more transparent and less complex since 1997…just the opposite. While a text-book scenario may look very logical, the recent/current condition of our financial markets is not conducive to a strategy that requires orderly derivative processing on crazy days. I have no issue with these products working as planned during normal market conditions (when you generally don’t need them); it’s the potential for extreme volatility that makes the whole idea questionable.
I’m not suggesting that you don’t use options within your portfolio. I’m merely saying that I’m not an advocate of this approach during volatile times, which I realize sounds odd…but think beyond the obvious. While I like using them in a more offensive mode (buying calls/puts), I think the comfort offered by this defensive approach is a slippery slope to a false sense of security. In the offensive mode, I realize I’m taking an aggressive position.
This is not an investment recommendation. As always, do your own homework and think for yourself. Best quote of the article:
“The put is insurance against a market tumble and, advisers say, is best used in a market that occasionally stumbles, not one that soars and collapses.”
Z Koolaid 