How to Hedge With Vertical Put Spreads

Includes: IWM, QQQ, SPY, XLF
by: Option Maestro

I always say it's better to have insurance before your house burns down rather than try to buy it as it's burning down. This can also be said when talking about purchasing insurance or put options to hedge an equity portfolio.

With the market up over 25% since early July and the market being quite complacent lately, volatility is relatively cheap making portfolio insurance or put options also relatively cheap. Many have been stating the market is overdue for a pull back, and I also believe a correction could occur whether it be worse than expected economic data in the United States, some bad news out of Europe or Asia, or even another flash crash that spikes fear in the markets, who knows what excuse the market will use to pull back, but it will likely find one soon as we all know trees don't grow to the sky. Another thing to remember is the more we rally before any type of pull back, the worse the pull back will likely be. A 25% move higher in just 6 months is certainly a gift and some of the profits made in the recent months should be set aside to hedge out the next few months, as I stated the greater the rally - the greater the correction is typically.

Historically when the market starts to decline it causes volatility to spike higher, making put options spike in price as well because volatility is a major component in pricing options. Therefore it is important to purchase put protection in times of complacency and when volatility is cheap (or when we don't really need it). In this article I will share in detail two option put spreads that would help hedge your portfolio if the market does happen to correct over the next couple months, which again I believe is very possible.

The 1 year chart of the volatility index is shown below, you can see the index spiked causing put options to be very expensive during the last market pull back from May until July. However if one owned put options before the pull back and major spike in volatility, it would have been more beneficial than trying to buy put protection as the market had already started down and volatility was on its way up. (click chart to enlarge)

Historically as the market rallies, the volatility index sells off and vice versa. However as the market has been creeping higher, with the Dow Jones Industrial Average recording its highest close since June 2008, the volatility index has also started to rally and many traders have been keeping their eye on this. It is important to note that the volatility index does tend to rally slightly during earnings season (because there's a lot more volatility in the market), but the volatility index rallied an above average 19.4% last week, which also happened to be a shortened trading week. Put option prices did increase with this increase in volatility, but they are still relatively cheap.

Now that you know when the best time to purchase portfolio insurance is, I will share with you how to put on a fairly basic option strategy called the vertical put spread. I will give two detailed put option spreads which can still be put on relatively cheap and could leverage protection to the downside of your portfolio.

The first step in structuring such a strategy is determining how much I am willing to spend on protection. I have no problem spending up to 2% of my portfolio value on protection when the market is as overbought as it is. The next thing I ask myself is how long do I want to protect my portfolio. This is the million dollar question because if you hedge too far out (or for a longer time frame) and the market continues to rally before finally getting any pull back or correction, the protection might be too far out of the money to hedge your portfolio. Likewise if you hedge too short of a time frame and the market doesn't correct, you may end up having to dish out money to protect your portfolio again soon, and if you are like me and dishing up to 2% out on protection you probably don't want to do that too often. I usually purchase protection for 2- 3 months at a time, as it gives me close to an entire quarter.

Using the very popular S&P 500 SPDR ETF (NYSEARCA:SPY) I will put on my first strategy. (click chart to enlarge)

The final step is figuring out how much I believe the market will correct. I think the market could correct between 5%-10% from current levels. Using the higher end of my estimate at 10%, this would set my target on the SPY to roughly 116. I would then be able to structure my option strategy.

As stated, I typically like between 60-90 days of protection so for this strategy I would purchase April put options with just over 80 days until expiration. I then would choose to purchase the closest to the money (but not in the money) 128 put options and sell (one for one) 116 put options against them (notice how I got this from my 10% lower from current level target).

As of current market data, each spread can be purchased for $290. If the market in fact sells off, this would give me protection from roughly 1,280 down to 1,160 on the S&P 500. The maximum profit from this spread would occur if the SPY closed at or below $116 per share on April options expiration. This would return $1200 per spread or a return of 413%. The most that can be lost from this spread is the premium paid of $290, and would result if the SPY closed at or above $128 per share on April options expiration. Commissions were not factored in the calculations above. Assuming I have a $100,000 portfolio that tracks relatively close to the S&P 500, I would purchase between 3-4 of these spreads. If we did in fact get a pull back and these spreads paid the maximum, this strategy would hedge my portfolio 3.6% (if 3 spreads were purchased) and 4.8% (if 4 spreads were purchased). As stated I would choose to put 1% into this spread, leaving the other 1% for the strategy outlined below.

Using another very popular ETF, the PowerShares QQQ (QQQQ) I would choose to put on my second strategy. If you are unfamiliar with this ETF it is an ETF which tracks the NASDAQ 100 or largest technology companies. (click chart to enlarge)

I like spreading my hedges out so I would choose a shorter term put spread to structure on this ETF. Using the same 10% lower target and the shorter time frame, I would choose to purchase March 55 put options and sell March 50 put options against them.

As of current market data this spread can be purchased for roughly $100 and would return $500 per put spread if the QQQQ closed at or below 50 on March options expiration. The most that can be lost from this spread is $100 and would result if the QQQQ closed at or above 55 on March options expiration. Assuming a $100,000 portfolio which tracks close to the NASDAQ 100, I would purchase 10 of these spreads. If we did get the pull back I am expecting and these spreads returned the maximum, this strategy would help hedge my portfolio 5%.

If we did get a correction and both strategies returned the maximum, this would hedge my portfolio a total of 9.8% for just 2% of my portfolio value, very close to the 10% decline I planned for and structured these strategies around. If small cap stocks are a large holding in the portfolio one should also factor in some put spreads on the iShares Russell 2000 Index ETF (NYSEARCA:IWM). We all have different holdings and this is just an example. If one is exposed greater to financial stocks, a great way to hedge would be purchasing some put spreads on the popular Financial SPDR (NYSEARCA:XLF).

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.
The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

Disclosure: I am long March QQQQ 55/50 Put Spreads

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