Hedging SPY With Options - Part 3

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This is the fourth installment in a series devoted to providing portfolio protection through options.

Whenever I address portfolio protection I am concerned, always, with 365-day protection. Minimizing the cost is an essential component. No strategy will be put into practice if it costs too much. I look for strategies that can actually be implemented.
My previous two strategies were based upon shorting the market in the near term and covering this short with a long dated call. Neither is perfect (perfect does not exist). One provides immediate yet partial protection, the other full protection but requires margin flexibility.
As a counter-strategy, I will offer one here that provides full protection and limited margin requirements. It is simple to understand and simple to execute. It is best instituted when volatility is normal or low and markets are near peaks (hats off to whoever knows when that is.)
Let’s set an example of protecting a portfolio that contains some cash and $120,000 in equities for 365 days. That is, willingness to accept daily fluctuations as long as in one year's time the portfolio will have lost nothing.
As I mentioned in previous articles, I use the S&P 500 (NYSEARCA:SPY) as a surrogate for the actual portfolio. SPY options have low bid/ask spreads, are highly liquid and generally reflect the overall market. It is just too expensive to try to match individual securities and impossible if the equity holdings include mutual funds.
To provide 365 days of protection I look to a Put Option 365 days ahead. In this case, September 2012. I set the strike price close to the current price (as of this writing $121.52). I will use a $121 strike that costs $13.70.
Normal strategy would buy 10 options. This would protect a portfolio of $121,000 (each option equals 100 shares). This is not a normal strategy and I buy an extra 30%, or three options. So, my total option buy is 13 and this costs $17,810.
The reason for buying the extra three options is that I will sell three puts against them to generate income to offset the $17,810 cost. The next step I undertake is to break the $17,810 cost down to a weekly cost $17,810/52 equals $342 per week.
In simplistic terms, if I can generate $342 per week selling 3 puts then over the 12 months I would have recovered my whole cost of the 13 puts. If the market has fallen, my long-dated puts will be in the money by the amount of the fall and will offset the portfolio loses. If the market is up after 365 days, I will have lost the full value of the long-dated put, but the $342 earned from the three puts sold each week zero-out this cost.
Ah, I wish it was that simple. There is a devil in the details. If the market moves smoothly this works simplistically. However, markets are not always so even. The SPY could start a Bull Run or run-up, then crash.
This strategy favors a down looking market, but runs into some difficulty in an up market. As the market moves up, volatility usually goes down, so the long-dated put loses some value on account of the price movement and the volatility decline. The volatility decline also means that the weekly puts that are sold will bring less of a premium. Not a double, but triple whammy.
So I implement a component designed to counter the up market problems. It is pretty simple ….. I set the strike price of the extra three options as high as I can and still earn $342 in a down market. For the three options I want to earn $1.13 per option. Looking at next week’s put matrix, the $123 put has a premium of $2.55. It is $1.48 in-the-money ($123 minus $121.52).
If SPY closes at $121.52 I realize only $1.07 ($2.55 minus $1.48). Slightly less than the $1.13 per week target, but close enough. If SPY closes below $121.52 I give back on the short put, but since it is covered by the extra three puts I gain it back.
If SPY closes at or above $123 (a weekly move in excess of 1.25%) I keep the entire $ 2.55 or nearly 2.5 times my weekly target. If it closes above $121.52 but below $123 I keep most, but not all of the credit. This helps to offset the extra loss attributed to the long put. Sometimes fully, sometimes not.
So, by selling the near-term put above the money I provide some hedge against a rising market. No market will consistently rise 1.25% or more each week, so this extra goes a long way.
What happens if the market does go up significantly over a few weeks? What if in several weeks SPY hits $130? Though there are gains for the $120,000 portfolio two new problems come into focus. You have taken a volatility hit on the long-dated call that could be as much as a few thousand dollars. But the bigger problem is that the put is set at a $121 strike and is “under-insured.”
What must be done in this case is to take advantage of the reduced volatility and increased value and re-set the long dated put. Sell the $121 put and buy a new put at $130. Though one can lament over the loss of a little money on the decrease in volatility, it now makes the purchase of the new put that much cheaper.
Simply stated take the small loss; take advantage of reduced volatility and lock in portfolio gains. It is a wonderful strategy that accepts a small loss when things are going up and avoids a big loss when things are going bad.
My last mention has to do with margin requirements. The only requirement is relative to the three in-the-money short puts. If sold two dollars above the long-dated put the margin requirement is only $600 ($2 times three options times 100 shares).
If this is an IRA or you are restricted from margin, the cash covered put is around $37,000 and when added to the cost of the long-dated put comes to over $55,000 total commitment. This sounds high for an account with $120,000 in equities, but for most people, their current cash/equity ratio exceeds this.
Since cash today earns next to nothing, I prefer to safeguard my portfolio rather than sell it off to raise more cash for protection.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I may purchase and sell SPY Puts and Calls