Hedging With Options Using SPY As An Example

Includes: SPY
by: Reel Ken

Investors are faced with many challenges in today’s environment. Many experts differ on their views of whether the market is headed up, sideways or down. I can’t and won’t make any prediction of how it will move. Wouldn’t it be nice if we didn’t have to worry about this problem?

Instead I will focus on portfolio insurance and how it can be effectively used to enhance your investment strategy. This is the next installment in a series of articles on this subject.

First, let me re-iterate what I’ve said in previous articles ... Portfolio Insurance is a 365 day a year necessity. Too many people wait until bad things start to happen. By that time they have already lost money and the cost of insurance goes up. Unusual events like the Flash Crash or terror bombings can happen so fast you won’t be able to react in time.

Second, I am not a big believer in accepting a 10% or 20% drop before the insurance kicks in. Most people don’t want to accept that substantial a decline.

So let’s first look at the real benefits of being “Fully Insured” 365 days a year. There are several benefits beside just “peace of mind”. Many of today’s investors remain on the equity sidelines. Maybe just 10% to 30% in equities and the rest in cash. Well, if your equity allocation was “Fully Insured” you could move to 40%, 50% or 60%in stocks without fear.

We all know that buying low is the right mantra. Few investors have the courage to actually do this as fear starts to set in as they see their portfolio shrink. Another advantage of being “Fully Insured” is that when the market turns down it is a lot easier to buy more. This can enhance your total upside significantly.

I would say that there is little argument against having this level of insurance. It is the COST that is the problem. With today’s volatility, buying Puts could easily run 4%-5% per month. Even if you went out 12 months it would run over 10%. This price is so expensive most people just do without, or compromise in the amount, duration or level of protection.

I would like to offer one way that you can use options to reduce the cost to a very affordable level (future articles will detail others). A level so low, that there is practically no reason to be without adequate Portfolio Protection 365 days a year. I call it my REVERSE BUY/WRITE WITH A TWIST.

Now, let’s put these concepts into action and detail how I provide “Full Protection” 365 days a year.

Let’s assume your asset allocation includes $250,000 in stocks that you want to hedge. I don’t try to insure each individual holding (which could have 20 or more stocks or even mutual funds) as it could be quite cumbersome and increases the costs. So, as a surrogate, I will short sell the SPY ETF. If you are invested in an IRA or have short selling restrictions, you can accomplish a synthetic short using options. If this technique is unfamiliar, there are plenty of articles you can research that will explain it.

Given the current price of SPY at $121(at the time of this writing) this equals a short of 2,000 shares (2,000 times $121= $242,000). However, I don’t short just 2,000 shares. I always short 25% additional so my total short will be 2,500 shares. As we progress you will see why this is crucial.

In order to protect myself from losing money if SPY increases, I will now buy 25 at the money call options. Since I intend to keep the “Protection” for 365 days I will buy the September 2012 $121 call. This costs $12.05, for a total cost of $ 30,125.

The concept of selling short and buying a protective call is nothing new. What is a little different, so far, is most traders look to short sell for limited durations and buy near dated calls, whereas I have gone for a long dated call a year out. Now, if I just stopped there, it would be expensive. Actually, over 12% of my portfolio.

What really separates this strategy, though, is the next step. Each week I sell five SPY “at-the-money” puts to generate income. This is why I chose the extra 20% short sale, to assure that these extra puts are fully covered against downside market risk.

Looking at the put matrix, next week’s put with a $121 strike gives a credit of $1.70. So my total credit for the five puts is $850 (remember, each put is 100 shares). As SPY moves up or down each week I just continue to sell five puts at whatever the price of SPY that week. Since I do this every week, if the option credit stays the same, I will collect a total of $44,200 in premium over the 52 weeks ($850 times 52).

So, let’s see what happens if the underlying closes each week at or above the strike of my put. Obviously, I get to keep the total $44,200 in premiums. This total premium received exceeds the cost of the September $121 call by about $14,000, so the combination of the Puts I sell and the Call I buy is in itself profitable and I have fully insured my portfolio for 365 days. In September the $121 call I purchased will be in-the-money by exactly the amount that the short sold SPY has lost. Overall, I lose nothing on the short sale and the $14,000 in net option credits remains my profit.

The cumulative option premium credits for selling the put vary with volatility. If volatility goes down, then less is received. If volatility goes up, then more is received. So, I can’t predict with certainty the total received, but even in normal volatility environs, it should be close to the cost of the long dated call.

What happens if the underlying SPY goes down? First your cumulative option credits still exceed the cost of the call by $14,000. The weekly put will lose $1.00 for each $1.00 that SPY goes down. But, and here’s the key, since I shorted an extra 500 shares of SPY in the beginning the entire downside movement in the put is exactly matched by the 500 shorted shares and I suffer no loss.

That means, whether the underlying SPY goes up, down or sideways I still receive a net option credit that is greater than the cost of the call. The “Protection” costs me nothing, and likely makes a small profit.

It needs to be said that the three elements in this strategy (short sale, long call, and short put) move at different rates and in different directions. This means that the results during the 12 month period aren’t in a straight line. All three lines will eventually converge at the expiry date as indicated. Some patience and perseverance is needed. You will not see exactly 100% protection and zero cost as you go along but it will be realized by expiry. Remember it is a 12 month “Insurance Policy” and that’s how long it takes to reach its maximum effect. At the end of the initial 12 month duration, simply buy another at-the-money call one year out and keep the strategy rolling.

One valuable side effect is available if the SPY moves down and you want to “Buy Low.” Say SPY has traded down from $121 and it is now $110. When it is time to sell the five puts, instead of selling them at-the-money you can, instead sell them above-the-money, say at $115. Since they are fully covered by your extra 500 short shares, there is no downside risk and you could pick up an extra few thousand dollars if SPY rebounds. You could also cover some of the short position, but I recommend against it.

Now the “nitpickers” will be sure to notice that my calculations don’t include negative dividends that would likely be assigned on the SPY. In fact, what I do is close the short just before the quarterly ex-dividend date and replace it with a month ending deep in the money short call. There are other “tweaks” that I use to improve the results, but these are best left for another article.

This strategy is intended to provide 100% protection for the portfolio at little to no cost. By varying the total shorted shares and the calls and puts you can achieve many different yet similar results. This will enable you to create a net long or net short variance as you move along.

On the downside, it does require weekly effort and patience. It is not for the novice or someone that can’t make the weekly trades. It requires a focused and objective effort.

Most importantly, though, shorting shares and selling puts have margin requirements. The long dated call requires ample cash. If the $250,000 stock portfolio represents all assets, you cannot enter the necessary trades. If, however, the $250,000 in stocks is part of an account that is, say 55% stocks and 45% cash and therefore includes about $200,000 in cash, there should be ample margin to enter this strategy, but you need to watch the margin maintenance requirements closely. Fifty/Fifty is the minimum asset allocation that I would recommend or you may need to pare down on the level of protection.

For those that can’t meet the short sale margin requirements, a synthetic short can substitute as a workaround, but it’s a little more complicated, increases the costs and is somewhat “messy.” I will cover this variance in a subsequent article.

Some might complain that the hypothetical $450,000 - $500,000 total portfolio with $250,000 in stocks is unrealistically high for the average investor. It is just an example, but this strategy isn’t for the average investor. A much smaller portfolio may not have the necessary flexibility to use this strategy. Furthermore, since you can’t use fractional options, a portfolio of less than $100,000 with $50,000 in equities to protect has too many “rounding costs”. In these situations, I suggest considering one of the portfolio insurance options in my past or subsequent articles.

For those that meet the criteria and are willing to manage the technical components and do the work it will pay off as indicated and is unequalled in both the level of protection afforded and the associative costs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I buy and sell SPY calls and buy and Sell SPY puts. I may purchase or sell SPY calls, and SPY Puts. I receive no compensation to write about any specific stock, sector or theme.

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