If your portfolio loses 1% today and gains 1% tomorrow, are you back to even? Not quite, but you’re awfully close. You actually need a gain of 1.01% to get back to where you started.

While that difference seems trivial, it gets magnified when the ups and down of your portfolio get larger. A loss of 5% requires a 5.26% gain to recover, while a 20% loss needs 25%. As for a 50% drawdown like we saw in 2008–09, well, that’s even worse than it appears. Your portfolio needs to double (a 100% gain) to return to its starting value. Stocks do recover from devastating declines like this, but it can take many years: the Canadian and US markets are still well below their 2007–08 highs.

Some investors simply don’t have the ability or the stomach to endure drawdowns of 20% or more. As index investors all know, the most straightforward way to protect your portfolio from catastrophic loss is to adjust its asset allocation: a 50-50 mix of Canadian stocks and government bonds lost just 12% in 2008.

But as I wrote about last week, markets are filled with uncertainty. We simply don’t know how far stocks can fall, nor can we be certain that bonds will be there to catch them. That’s why some index investors look for ways to build a floor under their portfolio.

Exploring your options

One way to set a limit on your portfolio’s losses is to buy put options. A put gives you the right to sell an asset—such as a popular ETF—at a certain price within a specified period. Here’s an example that was kindly provided by Alan Fustey of Index Wealth Management, the author of Risk, Financial Markets & You. (These prices were accurate as of May 1, but they will change with market conditions.)

With this strategy, no matter how far markets may fall in the next six months, you can’t lose more than 6.9%. Here’s why:

  • If XIU has declined below the strike price when the options expire, you have the right to sell your shares for $17. Since they were originally trading at $17.60, that works out to a maximum loss of 3.4%.
  • You also need to account for the premium you paid for the puts. At $0.62 per share, that’s an additional loss of 3.5%.

As you’ve probably figured out, this protection is not free. Remember that the cost of the options will reduce your return by 3.5% no matter what happens. The value of XIU needs to increase by 3.5% for you to break even, and if markets go up by 10% you’d get only 6.5%. (Note that we’ve ignored dividends here to keep things simple. With XIU you can add about a 1% dividend every six months.)

Calls for help

Clearly protective puts, as they’re called, are an expensive insurance policy. One way to lower the cost is to also sell call options on your ETF. A call gives the holder the right to buy an asset at a certain price within a specified period. You sell (or “write”) calls in order to earn income from the premiums. Here’s another example from Fustey to illustrate this strategy, which is called a collar. Again, prices were accurate as of May 1.

  • You buy the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
  • You purchase put options with a strike price of $17.00, expiring in six months, at a cost of $0.62 per share.
  • You also sell call options with a strike price of $18.50, collecting a premium of $0.30 per share.
  • Your net cost for the options works out to just $0.32 per share, or 1.7% of original value of XIU, about half what you paid for the puts alone.

Now the maximum loss you can suffer is just –5.2%. But with this strategy you limit your upside even further. If the price of XIU rises above $18.50 (about a 5% gain), the holder of the call options will buy the ETF shares from you at the strike price. You’d get the 5% gain, but no more. And once you factor in the 1.7% cost of the options, you’re guaranteeing that your maximum return over the six months will be 3.3% (plus any dividends).

Weighing the costs

There are a number of other ways to combine options strategies with index investing in order to limit catastrophic drawdowns and to generate additional income. When properly managed, they may be appropriate for investors who understand the trade-off. But while that trade-off may seem small when markets are trending down or sputtering along with single-digit returns, it won’t always seem so comforting. Investors will feel pangs of regret when they get left behind by a market surge like the one that began last October (US markets are up about 25% since then). As Fustey explains: “There is no free lunch that allows an investor to receive complete protection against loss without either an outlay of cash or capping upside return potential.”

For investors who are still in the accumulation stage—who have lots of time to recover from losses and no need to generate income—a traditional asset allocation strategy is likely to be far more efficient.