Faster Options Are More Fun

Let’s say you own a bunch of stocks, say $1 million worth of the stocks in the S&P 500 Index. You think they will go up (that’s why you own them), but you worry that they might go down. You can buy insurance against that risk: You can pay someone a fee now, and she will guarantee you that, in a year, your S&P 500 stocks will be worth at least $1 million. If they’re not, she’ll pay you the difference. (If they’re worth more than $1 million, you keep the gains, but she keeps the fee.) This is a put option.

The fee for that insurance is about $50,000: You pay about 5% of the value of your portfolio to insure it against a drop for one year. That’s kind of a lot? If the S&P goes down by 20%, you’ll be happy you bought insurance, but if it goes down by 4% you won’t be: You’d have been better off taking that loss and not paying 5% upfront. If the S&P goes up by 20%, you won’t mind your insurance that much — you still made 15%, net of insurance costs — but if it goes up by 5% you’ll be bummed; the cost of insurance wiped out all of your gains.