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.1 This 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 put options. The algorithm further enables investors who are willing to cap their upside potential to offset part of the cost of these put options by scanning for an optimal collar, in which a short call position is paired with the long put position. In scanning for the call leg of an optimal collar, the algorithm uses a process similar to the one it uses to find optimal put options, except in the case of calls it searches for ones that will provide the highest level of income without limiting the potential appreciation of the investor's position by less than the user specifies.
The algorithm searches for the lowest cost in obtaining the right number of options to ensure wealth is preserved. Our algorithm aims for options with expiration dates 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.
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.