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Medium-term horizon, long-term horizon, investment advisor
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Many people start analyzing option strategies by figuring out how much they stand to gain or lose. I’ve always taken a somewhat different stance. The first thing to do is create a THESIS for the underlying stock or ETF. Is the underlying stock or ETF going to go up or down and will it be fast or slow? Is the objective to earn money or protect an existing position? Is it a short term swing or expected to play out over time? How much is hoped for earnings and how much can be lost? And, of course, is the risk worth the reward?

Only after resolving these type of questions is the thesis complete. Then we can look to option strategies to provide the desired result. If there's no worthwhile match, then just move on.

The USA, represented by the S&P 500, seems to be in a slow growth or possible recessionary cycle. Unemployment is high, fiscal policy is a battlefield and monetary policy has deployed its biggest guns. Despite this, the S&P is only off a couple of percentages year-to-date. Contrast this with the global markets, where most are off 25% or more. I can understand Greece and Ireland, but Brazil, China, Canada, Australia and India? What has happened that caused these little darlings to slide so much in comparison?

“Does all this make sense”? It may to some well-informed pundits, but not to me. It seems that some “catching up” is inevitable. The S&P is either going down or these markets are going up. If the S&P is going up, than these will surely go up faster.

My crystal ball never did work so I don't know how it will all play out. I have to apply my own research and experience to resolve this issue. My first conclusion is that there is more downside risk on the S&P than some emerging markets. I think the S&P could go down 20% from here (or even more). I think some emerging markets also have downside risk, but not as much. Maybe 10%. Let me be clear, I am not suggesting that this will come to pass, merely concluding that one risk is greater than the other. There is a big difference between possibility of risk and likelihood of risk.

I already have in place portfolio protection for my existing portfolio. This protection guards against a 20% or more fall in the S&P. So I’m willing to try and seize an opportunity and take on some additional risk. I am going to look outside the USA for this, specifically Brazil and more specifically, the iShares Brazil Index ETF (NYSEARCA:EWZ). There are numerous articles and columns that discuss the merits of Brazil, so I won’t go into them here. The strategy discussed here can work with the country (or stock) of your choosing.

I don’t think EWZ is a guarantee by any means. There is still downside risk in every market. My thesis is that the risk is not as great as the S&P, yet I will still look to guard against a drop around 10% to 15%.

I think an excellent strategy to reach this objective is the Bear Call Spread, adding a slight modification. This involves selling in-the-money calls and buying another protective call at a higher strike price.

EWZ is trading at $57.55 and I will illustrate a planned investment of 1000 shares.

My first step is to determine the expiry dates. EWZ is a long term play, so I’ll go out at least a year, actually to January 2013.

Next I must determine the strike prices. I am looking to protect against a 15% drop. EWZ is currently trading at $57.55. In this case, I choose to sell the January 2013 $50 call with a credit of $11.95. In order to protect 1000 shares I need to sell 10 calls for a total credit of $11,950.

The next leg is to purchase the protective call. I will pick the January 2013 $60 strike call. This costs $6.75 per contract or $6,750 for the total 10 contracts.

The problem with any Bear Call Spread is that the cost of the protective call limits your downside protection and takes away from the upside. The following chart illustrates this.

Price

Profit / Loss

37.50

$5,200.00

44.70

$5,200.00

50.00

$5,200.00

52.27

$2,927.00

55.20

$0.00

59.85

($4,648.00)

60.00

($4,800.00)

67.42

($4,800.00)

75.00

($4,800.00)

As you can see, the loss going up is almost as great as the gain going down. But worse, if EWZ drops to $52.27 (around a 10% drop) the potential loss on the 1000 invested shares is over $5,200, yet the recovered gain is only $2,927.

It is my conclusion that this doesn’t really meet my requirements. So now I will look at a modification to improve this result.

If I can reduce my cost by $4,800 there will be a dramatic improvement in the result. The following chart shows what reducing my costs by $4,800 accomplishes.

Price Points

P/L

30.00

$10,000.00

50.00

$9,995.99

55.00

$5,000.00

60.00

$22.01

60.03

$0.00

75.00

$0.00

80.00

$0.00

85.00

$0.00

THIS IS MORE IN LINE WITH MY GOAL AND WORTH PURSUING.

So here’s how I will embark on reducing my costs by $4,800. First, I break down the $4,800 into a weekly cost. There are 65 weeks till the January 2013 expiry so that comes to $74 per week. This is my weekly target.

Instead of buying 1000 shares of EWZ, I will just buy 900 shares. Instead of the other 100 shares I will sell one weekly put on EWZ (each put contract represents 100 shares). My goal is to earn the $74 weekly target via selling the put. I need a credit of at least 74 cents to reach this objective. Next week’s $57 strike put credits $1.09 per contract so I will be credited $109 (more than the idealized $74).

Let’s project to January 2013:

1) If EWZ goes up I only gain on 900 shares instead of 1000. This is the opportunity cost of providing 17% risk protection.

2) If EWZ goes down to as low as $50, the $50 strike short call will gain at least what the 900 shares and the weekly put lose. Actually, the strategy will provide about $ 2,500 MORE than the shares and put lose. This represents a net gain of around 4%. Not bad for an otherwise losing investment.

3) If EWZ goes below $47.55 my protection stops and I lose as EWZ continues its retreat. The strategy didn't fail; my THESIS failed.

A couple of housekeeping mentions are necessary.

First, the actual result cannot be absolutely predicted. This is because the credits on the weekly puts will vary as volatility varies. However, it is reasonable to assume that the $74 weekly target can be met with puts near the money.

Second, instead of buying 900 shares and selling one put, 10 puts could be sold above the money. As long as they generate at least $74 in extrinsic value, the $4,800 will be met.

I must stress that this is not a “hit and run” trade. It is for those investors that would like to take a position in a beaten-down market. Even so, it provides a pretty acceptable cushion of nearly 17%.

Disclosure: I buy and sell calls and puts on EWZ.

Source: A Hedged Option Strategy On EWZ