I've finally bitten the bullet (gently) and bought my first real "derivatives" - I placed an order today to BUY 3 contracts for the S&P/ASX-200 index PUT option, 20-Dec-2007 expiry date. Each contract is for 1,000 'shares' (a strange terminology when you're buying index options) and the price range quoted when I placed the order was $1.44-$1.63. I started out telling the broker to set my buy price at $1.50 but he advised that this would take a long time to fill. I asked if the price varied more with time (ie. as we get closer to the expiry date the price should drop) or with the current value of the index (once you are "in the money" the contract is worth $10 per point at the expiration date). He wasn't terribly helpful, so I decided to bid $1.60 - so hopefully this order was filled.
The whole options trading thing is a bit of a pain - rather than just login and place an order with my normal online broking service, they have a special "power trader" application that provides live option pricing, charts etc. I looks really cool, but unfortunately I can't install it at work, and options trading is only available during market hours, so I can't use the software to trade options at home anyhow. So I have to phone the broker during business hours to trade options. Probably a good idea to start with, as I don't really know what I'm doing.
My geared stock portfolio is worth around $525,000 at the moment, with margin loans of $264,000. Hence my equity is around $261,000 at present. Although my portfolio doesn't exactly track the ASX-200 index, it does have a high correlation with the index. A change in the ASX index of 1 point is worth about $90 to my equity. Thus at my current gearing level a 2900 point drop in the index (just under 50%) would wipe out my equity entirely (but I'd be getting margin calls long before that!).
As each 1 pt decline below 5500 is worth $10 at the expiration date of an ASX200 5500 20-Dec-2007 PUT Option, I'd have to own around 9 of these PUT option contracts to offset the losses on my portfolio entirely below the 5500 level. I've started out by buying just 3 contracts today, as the market still seems to have upward momentum, and I might be able to buy additional contracts in future at a lower price (or ones with a higher strike price for the same cost). The three contracts will cost around 3*1,000*1.60 = $4,800 plus $100 brokerage. This equates to an "insurance premium" of 1.87% of my current equity. These contracts will reduce my losses below the 5500 level by around 1/3:
Full coverage for losses below 5500 up to 20-Dec would cost three times this amount (ie. 5.61%), so this strategy isn't sustainable indefinitely.
I'm only doing it now as the market seems to have reached dangerously high levels, plus the fact that I don't want to sell off significant holding and realise capital gains this tax year. I expect to start selling off some of my stock holdings after 1 July to reduce my gearing and start shifting my equity investments into a self-managed superannuation structure. This will mean that by the time the PUT options expire in December I won't have much of a geared exposure to shares (you can't directly use gearing within a superannuation account), and may have diversified some of this investment into other asset classes (eg. foreign stocks, commercial property, bond funds).
We'll see how this works out over the next 6-10 months.