What Portfolio Armor is:

An app that enables investors to insure their stocks and ETFs against market downturns as well as company- and sector-specific risk with put options.

Why put options?

Only put options protect you against losses when stocks or ETFs jump or "gap" downward. Limit sell orders don't do this. For more on put options, and how they can be used to hedge your risk, see Portfolio Armor for Individual Investors.

How it works:

You enter your stock and ETF holdings, and the maximum downside risk you are willing to accept for each holding. Then, using its proprietary algorithm, Portfolio Armor shows you the optimal put options to buy to obtain the level of protection you want at the lowest price.

Portfolio Armor for Individual Investors

More about put options:

Put options (often simply called "puts") give an investor the right, but not the obligation, to sell a particular security at a specified price (the strike price of the option), on or before a certain date (the expiration date of the option).

How put options can be used to hedge your risk:

Let's say you own a stock that is currently trading at $30 per share. The most you are willing to see this stock drop is 20%, which would be down to a price of $24 per share. If you own a put option on that stock with a strike price of $24, you would have locked in the right to sell that stock for $24 – even if the price of the stock drops below $24. Note that you would not want to exercise the put option when the stock price is above $24; this is why owning a put option represents the right to sell the stock rather than an obligation.

Not every stock or ETF has put options traded on it, and for those that don't, you might consider using a limit sell order. But limit sell orders may not protect you if your stock or ETF exhibits a downward jump in price. For example, consider the previous case, where you own a stock that is currently trading at $30 per share, and you don’t want to see it go below $24. This time, instead of buying a put option with a strike price of $24, you just place a limit order to sell your shares if they drop to $24. The risk you face in this case is that, in the event of significantly bad news, your stock could drop from $30 to $20, $15, or lower without trading at $24 on the way down.

In the event the stock price jumps downward like that, your limit order would not have let you sell at $24; on the other hand, had you owned puts on this stock with a strike price of $24, you would have been able to sell the stock at $24 even with a downward jump to a new market price much lower than $24.

Why use Portfolio Armor?

To find the optimal puts to buy to give you the level of protection you want at the lowest possible cost. Portfolio Armor uses its proprietary algorithm to instantly sort through and analyze all of the available put option contracts for your stock or ETF, taking into account multiple factors including premiums, strike prices, time to maturity, and the number of shares you hold in the security, and presents you with the optimal solution: the put option contract (or contracts) that will give you the level of insurance you seek at the lowest cost.

How much protection should I have?

In some cases, the cost of protection may be higher than the loss you are looking to prevent. In that case, Portfolio Armor will inform you that no optimal options exist. But aside from that, Portfolio Armor:

• Will tell you the optimal put options to buy based on the level of protection you specify
• Won’t tell you how much protection you should have

Each investor is unique and one investor's risk tolerance may differ from another's. If you aren't sure about what your own risk tolerance is, or about how much protection you should have, you may want to consult with a licensed or registered financial professional to discuss this.

Portfolio Armor's Proprietary Algorithm

More about Portfolio Armor’s proprietary algorithm:

The Portfolio Armor algorithm uses market information along with basic principles of option markets to present users with an optimal static hedge based on their specifications.¹This makes the put option position behave purely like an insurance policy on an investor's holdings. As with a term insurance policy, the premiums on the put option position should be considered a sunk cost.² The "term" of the insurance policy, in this case, is the time between when the investor buys the specified put options and when those options expire.

The insurance plan presented by the algorithm will, if implemented by the user, ensure that the user’s wealth does not decline below the threshold specified for each particular holding; but it will do so at a cost: the cost of the options. The algorithm searches for the lowest cost in obtaining the right amount of put options to ensure wealth is preserved. Our algorithm aims for put options with an expiration date approximately six months in the future, when these are available. Our research suggests that these options tend to offer the best combination of liquidity, cost, and convenience from the investor’s perspective.

Providing protection at the lowest possible cost

In order to ensure that it presents the insurance plan that provides the level of protection requested by an investor at the lowest possible cost, Portfolio Armor's algorithm includes a "positive hedging error". It rounds down the number of shares of the security an investor enters to the nearest hundred (because one put option contract represents the right to sell one hundred shares of the underlying security), and then over-insures the shares covered by the option contracts so that the total value of the investor's holding is protected as per the investor’s specifications.

For example, say an investor wanted to ensure that the value of 153 shares of XYZ wouldn't decline by more than 20%. To simplify this example, let's say the current total value of the investor’s 153 shares of XYZ was $1000. Portfolio Armor may present the investor with an insurance plan involving the purchase of 1 put option contract on XYZ. Because that 1 contract would only cover 100 shares, Portfolio Armor’s algorithm would increase the level of protection on those 100 shares, so that even if the value of XYZ dropped to zero, the net value of the investor's position in XYZ (stock and puts) wouldn't drop below $800 (a 20% decline from the initial $1000 value of the investor’s 153 shares of XYZ).

Because Portfolio Armor's algorithm rounds down the number of shares, there may be some cases where it presents no optimal options contract for a security position containing an odd lot of shares, even though there may be optimal contracts available for a slightly larger position containing only round lots.³ For example, say an investor wanted to ensure that the value of 199 shares of XYZ wouldn't decline by more than 20%. Portfolio Armor might inform that investor that no optimal options contract exists to provide that level of protection for the investor's 199 shares of XYZ, although there may be optimal contracts available to provide that level of protection for 200 shares of XYZ. The reason why Portfolio Armor does not present the optimal contracts for 200 shares of XYZ to an investor who indicates that he only owns 199 shares is because, if implemented, this insurance plan may result in a "negative hedging error" and net short exposure for the investor (because the investor would own more puts than underlying shares). If an investor tried to exercise his put contracts in this case, the investor could unwittingly end up with a short position, due to having sold one or more shares of a security he didn't own. The investor could end up exposed to uncapped risk on that short position. An investor should always consult with his financial adviser before considering taking on any net short exposure.