The 6-Week Options Trading Kickstarter: Hedging, Portfolio Protection, and Avoiding Disaster

By Steve Smith  SEP 27, 2012 5:00 PM

Steve Smith discusses using options to protect your positions and portfolio.

 


MINYANVILLE ORIGINAL

Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. If you are new to the 6-Week Options Kickstarter series, we recommend starting at the beginning with What Are Options, and Why Should We Care About Them? Note: Intermediate or advanced-level traders will get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.

When writing as an options educator and something of a proselytizer I try to keep in mind the Hippocratic Oath of doing no harm. So to avoid turning our little bit of knowledge into the roots of financial self-destruction, we’ll go through some tips that can help you avoid blowing yourself up. And then we’ll look at some ways options can be used to protect your positions and portfolio when outside forces turn against you.


Hedging and Protection

In my options trading at OptionSmith, I try to have individual positions that have their own internal hedges by using spreads. These usually take the form of basic vertical spreads or calendar spreads.  The essential function of a spread is that by both buying and selling options on the same underlying security, you will be reducing the impact of changes in implied volatility and time.  The strategy you choose will determine which variable you want to de-emphasize. 

I also frequently use options on the Spyder Trust (NYSEARCA:SPY) to provide the overall portfolio with broader protection. Typically, individual positions tend to be bullish, while the portfolio protection chunk usually consists of the purchase of puts or put spreads.  Let’s take a look at how this concept can be applied to a less active and basically bullish-oriented portfolio.

Buying put options does offer the most complete and probably efficient way to hedge a position, but it comes at a cost. That cost, as with all insurance policies, will be a function of the amount of protection and its duration.

The main items to consider when choosing put protection, whether for an individual stock or a broad equity portfolio, are as follows:  


Answering these questions will help you determine the appropriate number of puts to buy at a given strike with a certain expiration date. By using the basic application of delta, in which an at-the-money option is expected to move $0.50  for every $1 unit price move in the underlying security, one can begin to asses how much and at what levels cost protection can be purchased.

A great tool can be found at Schaeffers.com. Its portfolio calculator lets you play around with various levels of put protection for a portfolio of stocks representative of the S&P 100 Index (^OEX).

Combination Approach

If you're really looking for a true, longer-term hedge -- that is, you don’t expect to make many changes or adjustments to your portfolio for six months or more -- using a combination of strategies might make sense.

For example, I suggest the following three-step approach, which uses SPY options to create portfolio protection for a $150,000 portfolio:
 
1. Buy a put spread of closer to-the-money strikes that have about six months remaining until expiration. With the SPY trading around $140, one can buy the January $135 puts and sell the January $125 puts. Such a spread could be bought for around $2.50 net debit. For a $150,000 portfolio, purchasing about 100 of these might provide reasonable protection. But because we're protecting it in two other ways (read on), buying 25 spreads should suffice. 2. The next step is to sell a call spread for a credit, such as selling the January $145 calls and buying the January $150 calls. This call spread can garner about a $1.50 net credit. Remember, as a spread, this won't limit your upside. You could probably sell up to about 50 or 60 of these spreads. Just be aware that there's a "dead zone." If SPY is between 145 and 150, then you'll lose $3.50 on this position. But I assume you'd be making money if stocks rallied another 10% from current levels. You can use higher strikes or sell fewer spreads to align with your risk profile.
 
3. Finally, use the proceeds of the call spreads to buy some out-of-the-money (or OTM) puts outright to provide deeper downside protection. For example, the $7,000 proceeds from the call spread would finance the purchase of about 20 of the January $117 puts. These OTM puts give you outright disaster protection should the  market head back towards last October’s lows near the $110 level.
 
The total outlay would be about $11,000 -- or about 7% of the $150,000 portfolio -- which isn't too steep for over six months of portfolio insurance.

This is just a loose construct -- you can play around with the numbers -- but I think the best hedges will ultimately involve more than simply picking one strike.

Now if you're ready take on some more advanced options concepts, I suggest you read my 9 Weeks to Better Options Trading series.

Twitter: @steve13smith

No positions in stocks mentioned.

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