Protecting yourself by Insuring your Shares

How to Insure your Shares

The principle of Insuring your Shares is the same as Insuring your House or Car. And that principle is to protect your capital against loss.

The process of Insuring your Shares however does not involve ringing an insurance company and buying a policy. It involves using other stock market instrument to give you protection, and because it involves other stock market instruments it is much more flexible.

The insurance we buy for our shares is essentially buying a promise; that's what all insurance is right. In the stock market the promise that we buy is the promise that we will definitely be able to sell our shares at a pre-agreed price regardless of what the market does.

So if we insure our shares at $40.00, then even if the stock price falls to $2.00, we'll be able to sell our shares at the agreed insured price of $40.00.

We pay a premium for this insurance and the higher the insured price, the higher the premium. And, the longer the term of the insurance the higher the premium.  

So let's look at an example and then we can go into some of the detail.

Let's say we owned some shares called XYZ. We bought XYZ at $26.00 and it's currently trading at around $30.00. We could decide that we wanted to insure our shares at our buy price of $26.00 for a period of 1 year. This might cost us say 30 cents per share for one year of insurance.

Or we could decide that we want to lock in some profits by insuring our shares at a price higher than our original buy price. So we could insure at say $28.00 and this might cost 75 cents per share for a full year.

If we did this then no matter what happened to the share price we could sell our shares for $28.00, even if the company collapsed and it's price went to zero. If the stock price didn't collapse but did fall to say $25.00, and let's assume we wanted to still hold onto the shares, then we can sell our insurance. In this case the insurance that we bought for 75 cents when the stock price was $30.00, would now be worth more than $3.00; that's the difference between the current stock price ($25.00) and the price we insured at. ($28.00).

So you can see that insurance in the stock market is much more flexible than house insurance or car insurance.

Big investors treat the cost of insurance as a cost of owning shares. They simply won't buy shares without it. These guys often use this insurance to lock in profits for stocks that have risen in price i.e. they move their insurance price up, as the stock price rises.

Let's now cover some of the detail. The insurance contract that we've been talking about here is called a Put Option. An option is simply a promise and in this case we are buying a promise that someone else has made. You don't need to worry about finding the person or setting the premiums because the stock exchange does all that for you.

The Put Option we are buying has some terms to define exactly which option it is, because major stocks have heaps of option contracts available.

The agreed sell price of the insurance contract is called the Strike Price. The term of the contract is the Expiry Date.  And the amount we paid for the option is the Premium. So in the example above we bought a Put Option with a Strike Price of $28.00 and an Expiry Date one year ahead.  For this we paid 75 cents per share.

One Put Option contract covers a package of shares. In the US the normal number of shares is 100 while in Australia it's 1000. So if this was a US stock then one option contract would cost 100 x 75 cents = $75.00. This would allow us to sell 100 of our shares at the Strike Price on or before the Expiry Date, no matter what the current stock price was.

Take the time to get educated about Insuring your Shares as it's a valuable investing tool. But there's more to know before you start doing it.  A great way to learn all about it is with Paper-Trader Pro. You can then see the insurance contracts and the premiums and do all the learning and practicing you want,  in complete safety... Order Now

Note: This is not intended to be any type of financial advice. For investment advice you should seek the services of a qualified advisor.