SPY Option Hedge Strategy 16 comments
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Given the market's recent 50% runup from the March lows, it's probably not a bad idea to hedge your trading portfolio a bit with some options, right? (Read this article on How Stock Options Work for a refresher/beginner's lesson). The problem for traders and retail investors especially, is that most stock options expire worthless and you can hedge yourself into a downward spiral of expired options and trading commissions if you go overboard. Well, the 2 by 1 Put Spread Option Strategy is an inexpensive way to protect your portfolio against a moderate to severe downturn in equities with substantial gains if the underlying security ends up in the sweetspot.
Hedging with Puts - Basics
If you're talking about the prominent and liquid ETF that tracks the S&P500 (SPY), a simple way to hedge against a downturn in US equities would be to simply buy put(s) on the index. However, this can be rather costly and somewhat counter to your strategy, which for most investors, is net long over the long term.
- Thursday, SPY closed at $101.5 per share
- If you wanted to buy a put option with Dec expiry and 95 strike, you'd pay about $1000.
- That means SPY would need to drop down to 85 by December for you to break even (this assumes you aren't long SPY)
- That requires a loss of over 15% by year end. While this is completely feasibly, given the current trend, anything can happen.
Do you want to throw away $1000 trying to hedge a $20,000 portfolio twice per year?
That's a baked in 10% loss each time it doesn't work.
Hedging with 2 by 1 Put Spreads
I took a slightly different approach to hedging my trading portfolio against the recent runup. I entered into a debit spread and also sold an additional put at the low end to compensate for my higher premium paid for the long put at the top. I'll explain.
Last week, I entered into the following position (4x factor from model):
- SPY was trading at $99.6
- I bought 4 puts Dec expiry 94 strike for 4.36 each
- I sold 8 puts Dec expiry 84 strike for 1.97 each
- Note the 2:1 ratio
- Note that the sold puts almost equal the income from the purchased puts
- The net outflow per position is $42, so my total outflow was ~$180 with commissions
How would this play out?
In short, if SPY keeps going up, all the options expire worthless. That's fine because my overall portfolio continued to run.
If SPY drops, the long puts come into the money at 94 and keep gaining in value until SPY passes 84, at which point, the 2:1 ratio kicks in and you start to lose those gains.
Specifically, take a look at this chart:
click to enlarge
Note that in blue, you surpass the 94 strike and start accumulating gains shortly thereafter in green on the right. When you hit 84 in yellow, the gains start to diminish.
Risks: There's no free ride. You can lose money at low end. Why? Well, since you sold 2 puts and only bought one, if the market tanks precipitously and keeps going way past a 25% loss, the downward leverage of the 2:1 ratio overcomes the gains you made between 94 and 84. So, be careful and weigh your options (no pun intended).
My assumption here is that we may see at least one correction before year end, but I don't think we're going to test the lows the market hit in March. I think Financials especially have shored up their capital, housing is showing signs of bottoming and while the economy may not have a strong recovery, it's unlikely that there will be a rapid downturn from here. Obviously, the market has priced this in with a 50% rally, but as we've seen, anything can happen.
You don't need to set these strike prices 10 dollars apart. You don't need to use December expiry. There are myriad ways to set this up (I give away my excel models for free like this NPV model article - just drop in and leave a request if you want this one), and with the right model established, you could actually have a net positive inflow by shrinking the spread and generating more income than outflow. But this strategy isn't about making $50 on your options trade:
As you can see from the table, it's about turning a 2200% return if SPY drops to 83 by December.
In my case, with a 4x factor, this is $3600 cash generated during a market trough allowing for bargain hunting while others are selling.
So, what are your thoughts on the 2 by 1 Put Spread?
Disclosure: The author has an open position in the SPY 2 by 1 put spread examined in this article.
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For a small portfolio I believe the margin requirements would need to be considered. On my platform the trade requires $4100.00 of margin.
Somewhat of a diiferent strategy of protection I have used a butterfly trade. Other strikes may be considered, but using the basic example above with Dec expirations;
Buy 4, 94 puts
Sell 8, 90 puts
Buy 4, 86 puts
Net cost of $100 plus commission.
Margin requirement of $100.
Trade begins to lose below $86.25
Max profit $1500, Max loss of $100.
From my perspective it provides similar protection, less risk, less, margin.
Comments appreciated !
Thanks for the contribution!
If you option or option position vega is positive, you make money when volatility increases (when all other variables held constant). With negative vega, you lose money if volatility increases.
What happens when the market drops? Volatility increases.
These positions most likely will lose money if the market drops because they have negative vega. It's the opposite effect of the desired "insurance".
These strategies are like "rifle-shot" insurance, that is, they pay off ONLY NEAR EXPIRATION (When the option position's "positive theta overpowers the negative vega".. got it? :-).
If you want "real insurance", you need to research the option strategy of a diagonal (I use a "deep-out-the-money" double diagonals). It's a "shotgun approach" that's "costs a little more", but not as much as just buying puts.
If I have time and my comments generate a discussion, I'll come back in greater detail... BUT most people lose money trading options. They require a lot more knowledge than can be covered in a blog.
Which side of the diagonal would be the higher strike?
"...They require a lot more knowledge than can be covered in a blog." -- I promise I'll understand.
Yes, this was actually a pretty simply constructed strategy out of millions that could be imagined. I based mine on a model that assumes you hold the position to expiry and you tack on commissions at the end. It's not actually meant to be an "investment" or make money with high probability, but rather, to serve as a cheap way to insure the recent unprecedented runup in equities. If the position expires worthless because shares keep going, I could definitely still sleep at night. However, it makes good money on a wide range of S&P outcomes spanning from 7% to 24% loss, which is nice. It's important for traders using options to scale this with your overall position/portfolio for context. Like my example of losing $1000 on a $20,000 portfolio - not very palatable.
But on your suggestion to delve further into diagonals, I'd certainly love to hear more about it myself.
Thanks!
I took time to explain the "double diagonal" I mentioned in an earlier post; however, I can't paste pictures to this comment section so I posted on a blog (that I don't use but setup years ago). It appears you can comment on my blog but since I don't use it I would suggest you direct comments/questions back here. Here it is:
mileshoffman.blogspot.com/
Thanks for explaining double diagonal! Which option books are must-read?
Thanks!
Great explaination, and got me into exploring the TOS platform again. I've neglected doing that for a while, and I haven't been keeping up with the TOS webcasts with Dan Sheridan as I did when I was new to the platform.
I have bookmarked your post, I would definitely give my portfolio a similar shotgun blast if I were holding long positions. I've played this market rally by rolling up short puts. Instead of rolling them up again and hedging I'm just waiting for them to expire and taking gains. I.e. a 140 Oct AAPL put that I sold for $13.50 a few months back.
I did buy a SPY Dec '09 116 call for a buck today out of fear of underperforming the S&P if the rally continues upward.
> Milescfa,
>
> Thanks for explaining double diagonal! Which option books are must-read?
>
> Thanks!
As I thought I mentioned on my blog, I personally believe viewing all the CBOE webcasts featuring Dan Sheridan is the "must".
As for books, option strategies are so complex that no one book can explain 'em. Lawrence McMillan might be considered "the father" of explaining options (one of 1st) and he'll give you a good, sound basis. Sheldon Natenberg's "Option Volatility & Pricing" is recommended by many.
In the end, the best way to learn is trade 'em. You can use the SPY to keep risk (and reward) low, so start with Sheridon's Iron Condors. I've been trading them for two years and only now advancing to diagonals and dbl diag. It is mandatory to have a platform like Thinkorswim so you can explore how the P/L changes as you adjust strategies.
Anyway, thanks for your appreciation.
I enjoyed your post, curious as to with you wouldn't just stick with a calendar spread and save some transaction costs, still positive vega, still positive as price declines. I'm still learning and trading as I go and actually just took a position using a calendar and didn't really consider the double diagonal.
Jeff
EverdayFinance-> can you please send me your excel spreadsheets.
CS
Question, why did you pick 80C/75P? Also, wont you be loosing if SPY stays above $91. Do you have any article on portfolio beta weighted.
Regards,
CS
CS/CSG - perhaps the main reason for 75/80 is this play is primarily a hedge entering the SEP/OCT period when mkt can tank. It's insurance because it's below what should be strong support around 900+-25. This made it somewhat cheap (I've got this in SPX with $2k providing ~$20k "protection"). I know very little about port. beta wgt'g.
I assume everyone knows = click on TOS charts the enlarge them.
If you look at dd chart (4th), the green line says breakeven ("BE") is 93.60, ASSUMING NO CHG IN VOLATILITY. If volatility was drifting down, the "long far" options will lose value (relative to "short near")and the "BE" will drift lower than 93.60.
Look at chart 5, which is the essence of my post. Chart 5 is the one showing what happens if volatility increases by 10% (the vix is up by 4 already!). Both PL lines move up, so the upside breakeven moves higher.
FYI: PL today:
looking at the trade today with the IV incr, it's up about $15 on $165 "full" margin (9%), which my guess would be is mostly due to IV chg (SPY is 100.30 vs 100.79 when I "put it on"). Thus, it's insuring me!
Regards,
CSG
I edited my blog post slightly, giving charts # so you may follow text better. Also, I'm not sure how often I'll post here, but I love yahoo.com... Can't you guess my "e" address (but put "SA Options/Blog" or the like in the title so I won't think it's spam).
Note, as I said in my blog, Dan Sheridan is where I've learned most of my trading strategies. He posts "Option Safari" on the CBOE website and a couple of days ago he discussed "his bearish calendar stratey" for the SPY. His was VERY short-term (30days) and used NOT so out-the-money (so risk:return was even, not "long-shot" insurance like mine). Nonetheless, his frequent point is important to grasp... (paraphrasing) "How do you get hurt in options? Price and volatility movement." Thus he used a calendar to benefit from BOTH a price down move and the accompanying spkie in volatility (dbl diag=2 calendars=wider shotgun approach). Here's the link...
www.cboe.com/tradtool/...
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