Using Options to Protect Your Portfolio

There are a number of ways to use options to enhance your portfolio. You can use them to create a steady stream of income, you can use them to try to score big and make a killing in the short term, or as this article suggests, you can use them to hedge your bets and protect your portfolio.

Options continue to gain popularity and promoters of various option strategies seem to turn up everywhere.

Most of these strategies involve some form of income generation. That is, a strategy designed to make money under favorable circumstances.

Using options to protect (hedge) a portfolio is a completely different matter. In this way, the option trader is not trying to make money on an isolated strategy, but rather, to reduce loss if the market turns against his or her positions.

The best time to protect a portfolio is when the market is up and volatility is low. Success comes in anticipating and planning for bad things. Though it is a little late to protect against the recent market plunge, I will utilize current levels and volatility to explain some concepts.

We have all seen articles talking about how to use options to guard against losing more than, say, 10% or 20%. They usually involve buying an “out-of-the-money” put option (or Bear Put Spread) at some level below the current price. Though this can save some money it isn’t very efficient. For instance, once the market has gone down 10% or 20% losses are already significant. Shouldn’t you really be protecting against the first 10% to 20% decline and lock in your present portfolio?

Buying puts with near term (30-60-90 day) expirations is very expensive in the long run. As an example let’s look at the (SPY) ETF tracking the S&P 500. It is currently trading at a little over $119. If you bought the October 110 put (37 days to expiry) you would pay $2.30. Your “protection” is 7.5% below the current price and you will pay 1.75% for the price of the option. If you did this every month you would pay over 20% just to insure the portfolio after it drops another 7.5%. Now, if volatility is lower, this improves, but it is still prohibitively expensive.

Let’s debunk the theory that you only protect in risky times. The opposite is the truth. You must remain vigilant and should be looking at cost effective methods to protect your portfolio 365 days a year. You can’t predict the next Lehman, Flash crash or other major event. Constantly buying puts is too expensive.

It is my intention to post several articles showing how to provide 365 day protection at reasonable cost with not-so-everyday methods. This is the first and will utilize one of the simpler methods as it will lay the foundation for the future path.

I like to use the ETF SPY as my insurance policy. For several reasons-first, the bid/ask spread is reasonable, second it is highly liquid and third, my existing portfolio is “supposed” to outperform the SPY. Even if that doesn’t hold fully true, it is, hopefully, close enough.

Suppose a portfolio of $250,000. My goal is not to worry about daily, weekly or monthly fluctuations, but longer-term protection. For instance, if I can provide some protection over the next year I worry less about daily fluctuations.

The strategy offered here presents PARTIAL PROTECTION with an objective of minimal cost. Later articles will detail full protection.

This example utilizes a variation of a Calendar Spread (more accurately a diagonal Calendar Spread). This strategy employs simultaneously buying and selling two options with different expiry dates and strike prices. I will sell a near-term call (shorting the market) and buy a long-dated call to protect against a “run-up” in the SPY. If I don’t buy the long-dated call, I might as well just sit out the market entirely.

Calendar Spreads are common and every Options Software easily shows millions (if not billions) of possibilities. The problem most traders face is figuring out what strike prices and expiry dates actually work. This method reduces the quandary to simple math.

The first step is to determine the long-dated option. Since I am concerned about 365 day protection I will purchase an option about a year away. For this illustration – September 2012.

Next is the Strike Price. I choose a call at or around the money. In this case I’ll pick a $120 strike for a cost of $11.32. If I buy 20 options it will cost me $22,640.

The “tricky part” of the equation now enters. I break down the cost of the call per month (actually weekly works better, but is more difficult to illustrate). There are 12 months till expiry so the cost is $22,640/12 or $1,886 per month. Since I will sell 20 options this comes down to a about $.94 per option (each option is 100 shares). This is the critical number as I will base the sale of the near-term call so that I generate this amount.

Let’s look at a call matrix for October and see what we get.

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Option Trading Secrets