4 Options Strategies to Implement as Portfolio Protection
As far as volatility goes, we’ve seen a whole lot more of it so far in 2018. That’s in stark contrast to 2017, where we had record low levels of volatility. While this year has felt a lot more volatile, truth be told, it’s about average vs. the historical mean. The choppiness has made it difficult for traders and investors alike, as clear trends are not presenting themselves. Position yourself incorrectly and look out. It’s demanding a lot out of traders and discipline has been key. But some may be wondering, what kind of portfolio protection is out there?
Options are one considerations. But for many investors, options are either used a majority of the time or rarely if ever for others. Admittedly, options can be complicated, but when used correctly, they can be a great way to enhance (and protect) one’s returns. One way we can use options is for portfolio protection, helping to protect investors’ capital. Think of like insurance for your inventory.
Portfolio Protection #1: Protective Put Options
Perhaps the most obvious way to protect against a fall in the stock market is by purchasing put options. Investors have a nearly endless selection when it comes to using put options as portfolio protection.
If investors have a broad-based portfolio, they can simply buy put options on a broad-based market ETF, such as the S&P 500 ETF (SPY). If they have more tech exposure — such as owning FANG for instance — they can purchase puts on the Nasdaq ETF (QQQ). Investors with several bank holdings could buy puts on the SPDR Financial ETF (XLF). If it’s energy, they can use the XLE.
The list goes on and on. Of course, they can also purchase put options on individual stock holdings as well.
This is done by purchasing put options outright for a net debit. The advantage to this method is simple: for a relatively small amount of capital, investors can protect their entire portfolio against a large correction. The downside is obvious too though, in that the position could expire worthless and result in a total loss. That would eat into investors’ performance.
Portfolio Protection #2: Covered Calls
The alternative to paying out a net debit would be to collect a credit. One way to do this is by selling calls on long positions. Covered calls are simple strategies that can be used for multiple purposes. For instance, one way involves using covered calls to capture dividend payouts from companies while drastically reducing risk. They can also be used as portfolio protection.
In essence, it involves selling one call option for every 100 shares of stock.
For instance, if we own AMD and it’s currently trading at $15.50, we may consider selling the $17 call option. The credit received will help limit the losses should it begin to turn south. Conversely though, it will limit the gains should AMD begin to rally, but not until it eclipses $17 in this case.
It should be noted that a covered call will only protect against a slight decline in the underlying security. In this respect, the covered call isn’t the best portfolio insurance if investors believe a larger correction could be looming. To protect against that, there’s another way to position one’s portfolio, and that’s the next strategy.
Portfolio Protection #3: Collars
We can combine our first strategy of long puts with our second strategy of short calls. With it, we get the collar strategy. In essence, it involves selling one call option and purchasing one put option for every 100 shares of the underlying security.
For instance, if we own ABC and it’s currently trading at $22.50, we may consider selling the $25 call and purchasing the $20 put. Because these options are of equal distance in strike prices, we very well may be able to do this trade for a net credit of $0.00, or very close to it.
If ABC were at $23.50 and we put on the same strategy, we could actually collect a net credit if we use the same strike prices. This could be a great way to put on some portfolio protection without having to exit our position.
So where does the portfolio protection come into play? When expiration comes around, if ABC is trading between $20 and $25, nothing happens. We keep the stock, our collar expires worthless and all we’re out is the commission we paid to put on the trade. Seems harmless.
However, if shares were to plunge, say back down to $17, we’d be protected once ABC broke below $20. If we’re more nervous, we can use a higher strike price too, even if that means paying a slight net debit. Either way, this strategy is attractive because for the small price of limiting some upside, we can protect against a potentially large fall and do so without using much, if any capital.
Because the collar can be done for a small debit, no debit at all, or even possibly a net credit, they become a great form of portfolio protection.
Portfolio Protection #4: Bear Put Spreads and Bear Call Spreads
While the protective put it is a great way to shield one’s portfolio and bet on downside, its value can evaporate should the market rally unexpectedly. Similar is if the market fails to do anything but chop.
That’s why we have the bear put spread.
By buying a higher strike put and selling a lower strike put, it reduces the net debit paid. While we still pay a debit and risk total loss, the capital at stake is not as high and it still gives us plenty of flexibility. The downside is that it doesn’t give us as much profit potential should a larger correction really take hold.
For instance, with the SPY at $272, investors could buy the slightly out-of-the-money $270 put expiring in 24 days for (ironically) $2.72. However, if they were to make that into a $270/$265 put spread, they would only pay $1.07 for the trade, or just 40% of the original capital outlay.
The trade above is just for illustrative purposes. But you can easily see how much a short put reduces the overall net debit of the trade. Likewise, investors can sell upside call spreads, a strategy known as the bear call spread.
This works well when the market may only fall a few percent or even just stagnate. However, like the covered call, it will only protect investors on a slight decline and not against a larger fall.