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The 'Set It and Forget It' Market Hedge


This trade even has a slight tax advantage.

My firm has noted the incredibly low cost to buy market protection in the six month and longer time frame. Puts on the broad indexes are trading at the lowest levels that we have seen for 10% downside protection since the beginning of the debt crisis in 2008.

So, my co-author and I took some time to examine the option chain for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) this morning to see if we could find a collared position that we could put on in a long-term time frame. We found an interesting collared structure that we call "set it and forget it."

The SPY is the ETF that is indexed to the S&P 500 (INDEXSP:.INX). It currently trades at $152 and change. It is one of our favorite ETFs for seeking large cap US equity exposure. It has a very liquid and large options market.

We looked at the January 2014 expirations. That is 11 months away from expiration. You can purchase the puts at $135 strike for that month for around $4.45. That is about 11% downside protection from where the market trades today. That is an annualized cost to be hedged of about 3.2%. That is very low since we have been watching and reporting on the cost to hedge.

During the next 11 months, SPY will pay four dividends to its holders, totaling an estimated $3.00. So you can displace a large portion of the cost to be hedged with the dividend. That leaves the short call side to complete the collar.

If you want to target the difference after the dividend is paid, you would look to the calls you could sell in January 2014 expiration that collect around $1.45. These would be the $169 call strikes.

So, in this collar, you would have downside protection that starts at $17 down from $152 or about 11%. You would give away your upside at $17 above the current price – or again, 11%. So you would have a symmetrical performance profile for the price of the SPY ETF in exchange for forgoing the dividend.

We haven't seen this trade profile in some time, and it would have an 11-month risk profile. The part we haven't seen is the symmetry in upside and downside after netting the dividend. This means you could really set it and forget it. In the next 11 months, if the market trades within this range, you would realize all of the value of the change in SPY. Meanwhile, you would sleep well at night knowing that you have downside protection starting at 11% down in the market in case of a severe correction.

One last advantage this trade brings: The long put contract and short call contract both expire in 11 months – or less than one year. So for tax purposes, you would be able to treat them as short-term gains/losses and therefore they would be taxed at your regular income tax rate. Meanwhile, the dividends will be taxed at the lower dividend tax rate. So you actually get a slight tax advantage in this trade.

In addition, by the end of December 2013, you will probably already have a good feel for where this put and call will finish up. You could harvest the losses in 2013 by rolling the losing side in December and keeping the winning side in to 2014.

This strategy is truly set it and forget it for the investor that is comfortable with the +/-10% profile.
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No positions in stocks mentioned.
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