A Four-Step Strategy to Insure Your Portfolio
If you've experienced extreme market volatility, you know the importance of being covered.
I've recommended owning extra puts and calls as insurance against a major stock market move, but this insurance is only needed by traders who own positions with negative gamma, and who could otherwise be hurt by a big move.
There's no need to repeat the rationale behind this idea. But if you discovered for yourself (or wish you had) how important this strategy is when the market either undergoes extreme volatility or a steady, unidirectional move, then here's a simplified strategy you can use.
The trade begins with the sale of credit spreads. These can be calls, puts, or both (iron condor). You can enter the order at one time (recommended) or as two separate orders.
Step 1: Sell 3 credit spreads; for example, Russell 2000 Index (RUT) September 620/630. Assume you collect $1.80 per spread, or $540.
Step 2: Buy a naked call with a lower strike price. Specifically, 3 strike prices lower than the call sold. In this example, that's RUT September 600 call. The cost is significantly higher than the $540 collected. That means this is a debit spread and it costs money to own this position. Although debits aren't wonderful for premium sellers, they're part of the cost of doing business. Insurance isn't free.
This is a bullish play. If the market declines, you'll eventually lose the premium paid for the position (unless you accept the accompanying risk and sell your long call at some point).
If the market rises, you can never lose more than you invested (just as when you buy a call option outright). You have two decent opportunities for profit (see below).
Step 3 (optional): Do the same type of play with puts if you need downside insurance or want to make a bearish play.
Step 4: Although I recommend not holding positions through expiration, it's much easier to talk about the result of this play by making the assumption that this is held all the way. Obviously it's a good idea to exit the trade any time that you're satisfied with the profit or no longer need upside insurance.
If RUT is between 600 and 620 at expiration, the 600 call has value and you have a gain or loss, depending on how that value compares with the position cost. Maximum credit you can collect (at this price level) for the position is $2,000 because at 620, the September 600 call is 20 points in the money.
If RUT is between 620 and 630, you begin to give back some of the profit at the rate of $200 per point. Why? You're long one call and short 3 calls. Being net short 2 calls, you lose $200 per point and because it's expiration, your long calls don't provide any help unless they become in-the-money.
If RUT is at 630, your long call is 30 points in-the-money and worth $3,000. Your 3 short call spreads have reached their maximum value, and are also worth $3,000. Your net loss is the cash you paid for the position, just as if all options expired worthless.
This is the reason behind buying the September 600 call. You want the position to start accumulating value above the strike price of your long option. If you don't use 10-point spreads, or if you chose a ratio other than 1-3, buy the appropriate call instead of September 600.
Above 630, you earn $100 per point (as you'd expect to do with any call option), with no upper limit.
It's worth noting that if the long call is significantly in the money, it's going to be profitable to exit prior to expiration. Why? Two reasons:
1. Your long call still carries some time premium
2. The short spread hasn't yet reached its maximum value of 10.
If you decide to exit the trade, don't pay $9.90 or $9.80 for the 10-point spread. If you hold, you have a chance for a nice surprise if the market tumbles and the spread declines in price. Of course, there's a limit to how much to sacrifice. For me, that $0.20 is about it. For you? Remember, not closing is gambling with some of your profit.
This isn't perfect protection. There are areas at which you have no benefit. In exchange for that, you get to buy a well-struck (that is, a good strike price) call at a good price.
This is just another way to accumulate insurance.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter