Over the last several weeks I have published a number of articles detailing ways of providing Portfolio Protection 365 days a year. I stress the importance of taking some action, and not just waiting until doom is imminent. When the market decides to go down, it is usually fast and furious. If market declines were steady and predictable, no one would lose money.
The issue with 365 day portfolio protection is never the reason, but the cost. My previous articles showed how costs can be reduced to manageable levels.
I would like to change the focus a little, but still employ some of the methods I detailed previously. The examples given here use current options pricing (as I write this article), which has an unusually high volatility component. Though the concepts are solid, at lower volatility the numbers "tighten up". I'll include, parenthetically, what I would expect more normal values to be. I hope this does not create too much confusion.
If you adopted any of my strategies, you already have portfolio protection. You are ready for the next step.
One year passes, the market declines, protection works as indicated and your portfolio is intact. But you have not made any money, and since time is money, you have lost a year-- therefore you have lost money.
Everyone likes to make 10%, 20%, 30% or more in an up market. In a down market I’m happy to make 5%. So let’s embark on a strategy that can complement your portfolio protection and provide positive returns (5%) if the market declines or stays flat. I will use the SPY
ETF as a surrogate for the portfolio.
Assuming a portfolio of $250,000 my strategy needs to make $12,500 to reflect that 5% return. To accomplish this I will institute a VERTICAL BEAR CALL SPREAD.
It has two components, so let’s go into some detail on this.
Bear Vertical Call Spread: This strategy consists of selling an in–the-money call and buying a higher strike protective call. Let’s look at SPY, currently trading at $113.54. A 12 month in-the-money call, 5 points below the current closing price at $108, will result in a credit of $15.46 (normal around $11). If SPY doesn’t change value by expiry, the $5.54 that’s in the money will have to be given back. The extra $ 9.92 (normal $5.46) is gain.
Definitions will help us. The $5.54 give back is the Intrinsic Value of the option (easy to remember IN the money.) The $ 9.92 is the Extrinsic Value (easy to remember EXTRA). Combined they equal the $15.46 premium.
If SPY goes down, intrinsicvalue becomes gain and adds to your $ 5.54 of extrinsicvalue. If SPY falls to $108 or below, all the intrinsic and extrinsic value or $15.46 (normal $11) represents gain.
If SPY goes up, the extrinsic value starts a "give back". If SPY goes up by $9.92 all the extrinsic value is lost and breaks even. If SPY goes up $12, the $ 9.92 in extrinsic is absorbed AND an additional $ 2.08 net loss. SPY continues to rise, losses continue to mount. To prevent this loss, the protective call comes in. There is no loss until SPY moves up by $ 9.92. I will buy a call $10.00 above the money (normal $6 above) to offset the potential loss. This costs $ 7.98 (normal $4).
Remember, I want to make $12,500 in a flat or down market. My first calculation is to compute how many options I need to generate a $12,500 profit if each option has an EXTRINSIC value of $ 9.92. The answer is simple math: ($12,500/9.92) = twelve options (normal $12,500/5.46 equals 22 options).
Summarizing, I will sell 12 (normal 22) SPY call options 365 days out and $5 below the money. For protection I will buy 12 (normal 22) protective calls $10.00 above the money.
The protective call costs $ 7.98 (normal $4) and eat into my extrinsic gain. I need to recoup this amount for my strategy to succeed. The total cost of the protective put is 12 options times $ 7.98 or $ 9,576 (normal 22 times $4 equals $8,800). Divided by 52 weeks it comes to $ 184 per week (normal $ 170). I will sell weekly puts to generate this income.
Initially, with volatility extreme on at-the-money puts, selling only one put at $2.00 generates $200. Over time, more normal volatility is 80 cents, so 2 puts on average would need to be sold.
These two puts incur risk if the market turns down. Offsetting this risk is the intrinsic gain that will come into play on the initial call sold $5 below the money. If the market drops by $5, that will represent an additional $6,000 (12 options times $5 intrinsic gain).
There are only two puts sold each week. If the market drops $5, the loss on the puts is only $1,000. The puts would have to show a loss of $6,000 before any downside. Well, $ 6,000 divided by 2 puts is a downward move of 30 points
. Though I could buy a long dated put 30 points below the market to protect this, I just choose to ignore it.
In a "whip-saw" market setting the strike on the two puts is challenging. When volatility is high, I suggest setting the strikes somewhat above the market-- and when volatility is low, somewhat below the market. By doing this you will gain sometimes and lose sometimes. Your gains will be when the market drops, and your losses when it rises. This is never a bad plan.
So where does this leave us?
In a flat market earn the intrinsic value of $12,500.
In a down market earn the intrinsic vale of $12,500 unless the market drops 30 points. I choose not to insure this, but I could.
In an up market earn the intrinsic value, but will slowly give it back as the market rises and will have given it all back if the market rises by $9.92. This represents a rise of about 8% before being "zeroed out".
In conclusion, earn 5% in a flat or down market. In an up market, regular portfolio gains plus a little extra if SPY moves less than 8%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I may buy or sell SPY call or puts