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Using Options to Protect Profits

Online Trading Academy
Wed Apr 09, 2014 10:02 EST

On April 2, 2014, the S&P 500 Index notched to another all-time high, closing in on the 1900 mark (points, not the year). From the lows following the 2008-2009 crash, the index has climbed by over 180%. It has exceeded the 2007 high by over 20% (in nominal terms).

Here is the chart of the S&P 500 as it stood on April 2, 2014:

SandP500 1995 to 2014
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Click to enlarge

In real (inflation-adjusted) terms, the index had exceeded the 2007 high and was within a hair of exceeding the real all-time high, which was made in 2000.

The following chart, from,multpl.com, shows the long-term inflation-adjusted chart for the index:

SandP500 Real Price






















Click to enlarge

After a run like this, an increase of 180% from the 2009 lows, could the top be far away? Well, yes, it could. Or not.

When the great bull market of 1982-2000 had come this far, it was just getting started. Anyone who got out after "only" 180% missed most of a bull market that eventually saw over a 1,200% gain.

So where are we now? Standing on the brink of a great crash as in 2007? Or just in the warm-up stages of another epic bull as in the 1980s?

I don't know. Neither do you, nor does anyone else. There are excellent, nearly irrefutable arguments for both sides of that question. You hear them every day from all of the talking heads.

So, in practical terms, how can investors and traders continue to participate in further upside moves, while protecting ourselves in the event of a crash?

Here are a few alternatives using options:

1. Hold long-term positions, and buy put options as insurance.

2. Add covered calls to the long stock and puts, creating collars.

3. Substitute bullish vertical spreads for the collars, reserving the excess cash.

4. Convert most of a portfolio to cash. Use a small percentage to buy long-term call options to maintain exposure.
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Let's look at each one briefly today. In the future, I'll explore them in more detail.

1. Hold long-term positions, and buy put options as insurance.

This is a very straightforward way to buy protection. In this simplest of all uses of options, you just buy yourself an insurance policy. If the bull market continues, you participate fully, minus the cost of the insurance. Here are two slightly different ways this could work:

First Alternative: With the SPY (the exchange-traded fund that tracks the S&P 500 index) around 189, options are available as far out as December, 2015. You could buy a zero-deductible policy by buying the December 190 puts for about $18. The 9.6% cost , over the 623-day term of the puts, amounts to an annual premium rate of about 5.6%.

Second Alternative: Buy a cheaper policy with a higher "deductible." If you are willing to absorb a 10% loss in your portfolio before your insurance kicks in, the cost will be less. The December 2015 puts at the 170 strike would cost about $10.50. This amounts to an annual premium cost of about 3.2%

With both of these alternatives, your upside profit is unlimited, while your downside is protected. Which of the two will pay off better depends on the severity of any downturn. If there is no downturn, then no insurance would have been best. If losses turn out to be only minor, then the cheap insurance will have been adequate. If the market tanks severely, the buyer of the zero-deductible policy will look like the genius.

2.,Add covered calls to the long stock and puts, creating collars.

In this variation, you add short calls to our long stock and long puts. The calls pay part or all of the cost of the puts. The tradeoff is that your upside is now limited.

For example, a December 2015 call at the 210 strike would bring in about $4.50, covering a quarter of the cost of the zero-deductible 190 puts, bringing their net cost down to $13.50, or about a 4.2% annual rate. The real cost, though, is the opportunity cost. If SPY increases beyond 210, you do not participate. You have limited yourself to, at most, a $21 gross gain (210 - 189). After subtracting your net insurance cost of $13.50, your maximum net gain would be $7.50. Calls at higher strikes would reduce cost less, but provide more upside headroom.

You could improve the performance of the collar by diagonalizing it -- buying the puts now, and then selling individual one-month calls each month. Each month's call strike could be determined by chart technical indications at that time. Ideally, you would keep the call strike just out of reach each month and end up with both the stock and some call premium in our pocket.

3. Substitute bullish vertical spreads for the collars, reserving the excess cash.

You may have worked out that the collar strategy is just a variation on a bull call spread. The collar uses puts to limit downside risk, and also has limited upside because of the short calls. This is exactly what a bull call spread does. In the first collar example above, you own the SPY and also puts at the 190 strike for a total cost of 207 (189 + 18). You are short the 210 calls, allowing for a $3 maximum profit.

You could substitute the 189 December 2015 calls for the SPY stock and puts. The calls give the same risk profile as the protected stock: unlimited upside and limited downside. The difference is that the protected stock costs $207 per share, while the 190 calls cost $12.50. (There are other differences, too. The protected stock will still be there when the put options expire. The calls will not. The protected stock will also pay dividends.)

With the bull call spread using long December 2015 190 strike calls at $12.50 and short December 2015 210-strike calls at $4.50, you risk a net of $8.00 ($12.50-4.50). Your maximum profit is the $20 difference between the strikes (210 - 190) and the $8.00 cost of the spread, or $12.00. This is a better profit at a lesser cost than the collar. It would also allow you to take most of your money off the table now, using just a fraction of it to buy the spreads ($8.00 per share in place of $189 for the unprotected stock).

This brings us full circle to the next option.

4. Convert most of a portfolio to cash. Use a small percentage to buy long-term call options to maintain exposure.

You could simply sell here to preserve your profits, converting our stock positions to cash. You could then use a fraction of the proceeds to buy call options to regain your upside potential. In fact, this option is very similar to option 1 (keep the stock and buy puts), but with most of our cash in our pockets. You have limited downside (the cost of the calls), and unlimited upside. The main difference is that our calls will expire, while the stock will not. In times of "normal" interest income from cash holdings, this is a very attractive strategy.

Which of these is best? As is often the case, there is no way to know ahead of time. The more conservative your stance, the less profit potential you have. Each one of these would turn out to be the perfect strategy with a particular market. You just don't know which market you'll have.


Editor's note: This story by Russ Allen originally appeared on Online Trading Academy.

To read more from Online Trading Academy, see:,

The Biggest Challenge New Traders Face

Stretching the Price

The Forex 'Experience'

 
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