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Three Option Plays to Protect Your Portfolio From a Market Plunge

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The strategy you choose will be a function of the magnitude of the move and the time frame in which you expect it to occur.

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Even though the stock market enjoyed a bounce yesterday and the S&P 500 (INDEXSP:.INX) seems to have held the 1560 support level, many are viewing the recent volatility as a mere shot across the bow, and expect a much larger decline in coming months. Bears on various fronts, valuation investors and technicians, and macro policy pundits make compelling arguments that May 22 marked an important turning point.

As the S&P 500 marched higher during the first five months of the year, it was mostly due to multiple expansion in which the S&P's P/E went from 13.5 to 15.8 at the peak. This was not supported by earnings growth in which the top line was flat and bottom line profits grew by just 3% over the first quarter.

The price action on May 22 was technically very bearish. The S&P 500 put in an intraday day high of 1687 and then closed down out 1655; this was not only a key reversal on the daily chart but also on the weekly chart, indicating a major top. It also represented a false breakout, which often leads to a sharp countermove as investors are caught leading the way. You could say the recent 5% sell-off from that intraday high represents that countermove. From the intraday peak to Monday's intraday low, it was a 7.6% decline.

But the trigger was the possible policy change coming from the Fed, concerning QE and ultimately a hike in interest rates. Combine this with slowing global growth and many believe that a decline of 20-30% is coming over the next six to 12 months. While it may be a low probability when viewed against the backdrop of the nearly 150% rise over the prior four years, it has to be considered a distinct possibility.

Let's take a look at three ways that you could use options to both profit and protect your portfolio if the stock market resumes its decline. As always with options, the strategy you choose will be a function of the magnitude of the move and the time frame in which you expect it to occur.

The Thomas Hobbes Play

It's a well-worn saying that markets take the stairs up and the elevator down. Indeed the bulk of the recent decline occurred after last Wednesday's FOMC meeting and Chairman Bernanke's following testimony. Measured from last Tuesday's close to Monday's close, there was a 5.2% decline in over four trading sessions. This essentially wiped out the prior five weeks' gains. So far, this correction is proving to be nasty, brutish, and short. But if you think this rebound is simply setting up for another quick leg down, then it would make sense to look at using near-term options to capture the next nasty sharp stroke down.

My suggestion would be to use weekly options in SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which are currently being listed three weeks at a time on a rolling basis. For example, there are SPY options that expire this Friday, June 28; next Friday, July 5; and even the following Friday, July 12. After that, they go back to the standard third Friday of the month expiration cycle. A spokesperson from the Chicago Board Options Exchange (CBOE) was non-committal, but I think these consecutive weekly listings will continue as long as market volatility remains elevated. The precedent being that while certain high-profile names such as Apple Inc (NASDAQ:AAPL) or Amazon.com, Inc. (NASDAQ:AMZN) always have weekly options, second-tier issues like eBay Inc (NASDAQ:EBAY) or Salesforce.com, Inc (NYSE:CRM) will get the weekly option listed prior to an earnings report. Consider the next few weeks to be one giant earnings report across the S&P 500. But I digress.

If you think that any resumption to the downside will also be of the dislocation or event-induced kind, then buying low-cost, near-dated put options will give you the biggest bang for your buck. The put options will increase in price not only as a result of the decline in the underlying price, but also because of the accompanying spike in implied volatility that would typically accompany a sharp sell-off. The spike in implied volatility is usually greatest in the nearest term expiration as later-dated options will price in a reversion to the mean or expectations that things will settle down over time.

But be aware: A low dollar amount does not necessarily make an option "cheap." Current implied volatility levels are still elevated, especially for short-dated options. For example, the at-the-money (ATM) SPY options that expire this Friday have an implied volatility of 19%, which is significantly higher than the 15% one-week options were running five days ago, and above the 16% level that options that expire on July 20 currently sport.

Also keep in mind that time decay, also referred to as theta, accelerates as expiration approaches -- meaning these assets are rapidly wasting away. All else being equal, the $160 puts that expire this Friday are losing $3 per day in decay, and that will increase with each passing day. By comparison, the $160 put that expires July 20 is currently losing just $1.80 per day.

A program of continually purchasing short-term puts on a rolling basis could prove costly if the market rallies or even stays flat due to the time decay. But by my back-of-the-envelope calculation, if another 5% decline in five periods were to occur, it would more than pay for eight weeks' worth of put purchases that had expired worthless.

The Dante's Inferno Play

If you think we are entering a new secular bear market that will slowly descend into a hellish 20-30% decline, then taking a longer-term approach makes sense. (Trying to figure out a strategy for each of the nine circles is beyond the scope of this article.)

Let's make the assumption that the S&P 500 (or SPY) will decline 25% from its current levels by the end of the year. This might be considered the sixth circle (or heresy), as that would place the S&P 500 around 1200 and the SPY around $120 per share, or down nearly 15% for the year. If this were to occur, it would most likely take the form of dropping and filling or dripping lower rather than a sudden waterfall.

In this case, it might make sense to look at much-longer-term options that are further out-of-the-money and use a spread to limit the impact of time decay. A basic vertical spread consists of the simultaneous purchase and sale of two options with different strike prices but the same expiration.

In this scenario, if we are targeting $120 at the end of the year, we might buy the December $155 put for $4.75 per contract and buy the December $125 put for $1.25 per contract. That is a $3.50 net debit for the spread, which represents the maximum loss if the SPY is above $150 on the December expiration. The maximum profit is $26.50 (the width between strikes minus the cost of the spread, or 30 - 3.50 = 26.50) and would be realized if SPY is below $125 at expiration. I chose the $125 level for the lower strike to provide some cushion so that if our downside target of $120 was reached, the spread would be fully in the money.

The drawback to this approach is that it's hard to realize the full profit prior to expiration. This is because both the long and short options will have time premium. So if the market were to tumble 25% during the next two months to be at $120 at the end of August, my calculations tell me that the spread might only be worth about $20 -- not bad, but still 24% shy of the maximum profit.

The Limited High Play

Our third thesis is not necessarily bearish, but it is based on the notion that the market has seen its highs for the year and will most likely meander sideways in the coming months. In this case, it might make sense to sell call premium on the notion that further upside is limited. Selling calls would allow you to profit through time decay and the likely decline in implied volatility of a range-bound market as you would collect the premium of the options sold.

Typically it makes sense to use an option that is slightly out-of-the-money and has between 30-60 days until expiration. This gives you some breathing room to the upside and also allows you to capture the acceleration of time decay. This can be done on both indices or ETFs, or on individual stocks.

This technique is often used when one already owns shares in a particular security, and it is then referred to as overwriting or a covered call. It is a way to generate income, and it also provides some limited downside protection.

If one does not own the underlying shares, I would suggest selling a spread for a credit to avoid being "naked" short and exposing yourself to unlimited losses should the market move sharply higher.

As with all option strategies, these can be tweaked in terms of time and strike prices to conform to your market thesis and goals.

Twitter: @steve13smith

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