This article is another in a series that I have started with the objective of illustrating various Portfolio Protection methods using options. So far I have detailed three different methods:
- A Calendar Call Spread on the SPY ETF.
- Shorting SPY, buying a protective call and selling a few short dated puts.
- Buying long dated puts and selling a few short dated puts.
All of these strategies include buying a long dated (one year out) Option. Any of these three strategies are best employed at market highs. Buying the long dated options is best if purchased when volatility is low. If you did or do this, and the market falls you will be in good shape.
Unfortunately, most people substitute Hope for Risk Management and haven’t provided themselves adequate protection. They may have missed their best opportunity, but they haven’t missed their only opportunity.
The SPY has dropped from $137 to as low as $110 over the last few months. It is in a trading range currently of between $114 and $124. Volatility is relatively high and the VIX is running between 30 and 40. It is a tough time to be looking at long dated options.
As such, this article will explore a portfolio protection technique that can be instituted when the market has fallen and volatility is high. If I was totally scared I could just go with the aforementioned strategies and pay the piper. Instead I’ll make some sacrifices and compromise, but closing the barn door now can at least keep some animals inside.
Once the market has fallen it has several characteristics that can be used to advantage. First, we may be safe protecting against only, say, an additional 10% further drop. Second, when volatility is high it favors SELLING options, not buying them. Let’s incorporate these characteristics.
Step one is to sell a long dated vertical call spread. I’ll sell a deep-in-the-money September 2012 call with a strike of $105 and receive a credit of $21.08. This means if SPY goes down I’ll pick up the down move all the way to $105. If it goes to $105, I get to keep the $21.08 premium. So, I get only $21 of downside protection, no more. Compromise #1.
If SPY moves up, it would have to climb higher than $126 before I lose on the call ($105 +$21.08). So, I will protect against that and purchase a September out-of –the-money call with a strike of $126. This will cost me $8.54. If I just stopped there my downside protection is reduced by the $8.54 and reduces to a maximum of $12.54 in protection.
Those that have been following my previous strategies probably have guessed that I will add a component to reduce this cost.
Here’s how I do it. Assume I’m looking to protect a $250,000 equity portfolio. Normal methods would enter the vertical spread at 20 options. With SPY at $120 that’s $240,000 exposure protected. Instead, I will enter the trade for 25 options (25% more than I seem to need). In effect, I have "over-protected" by five options. These extra five options are crucial.
So, my out of pocket cost is the 25 long call options at $126. The cost of these 25 long options -25 options time $8.54 or $21,354. I break this down to a weekly TARGET. Simple math $21,354/52 equals $410 per week.
Here's where the extra five short calls come into play.
I sell five weekly SPY puts at the money. Since I sold an extra five call options, any downward move in these five options is covered down to $105.The weekly credit is $1.87 or $935. This is more than the target $410 and I gladly accept volatility working in my favor.
Over time, if volatility decreases I’ll receive less, but it should easily cover the average $410 per week that I’m targeting.
So, in the end, I plan to recover the entire cost of the $126 call and restore my protection to the full $21. Remember the net protection is for twenty options so the maximum protection value is $42,000. That means the portfolio is covered for a downward move of close to 17% ($42,000/$250,000). Not perfect, but we were late to the game.
If SPY moves upward, the $126 call (which after selling puts has no net cost) covers any potential loss.
In conclusion, portfolio protection can be instituted at any time. There are optimum times and not so optimum times. One need only vary the strategy employed to meet the current conditions.
Using a vertical call spread as the foundation does not provide full protection. But when volatility is high is takes advantage by selling long dated options instead of buying them.
Disclosure: I may buy or sell SPY call or puts