I Hedged This Insane Market Runup with a Put Spread – Here’s How

by Darwin on April 1, 2010

I was reminded by a blogging buddy of mine Evan (via Twitter) about just how insane the market has been lately and that perhaps it’s high time to buy some insurance.  While I don’t play games with the funds in my retirement accounts and remain fully invested at all times given the multi-decade time horizon, I also have a trading account that I’ve done quite well with by reacting to near-term over and under-reactions we’re so accustomed to in the market (here’s my last portfolio update).  Given the unprecedented run stocks have seen which seems a bit overdone in light of how screwed up our economy is, I figure we’re long overdue for a typical retrenchment (market correction) since we haven’t seen one for months.  In my initial article on How Options Work I introduced readers to the basics of put and call options.  This week, I decided to buy some downside protection with a Put Spread on the broad market index the S&P500 via the ETF (SPY).

Why Hedge with a Put Spread Now?

The premise here is that I have a decent sized long portfolio with a market-neutral component (I make money regardless of market direction by employing Darwin’s Short Leveraged ETF Strategy).  If I spend a little money on a downside hedge like a put spread and it expires worthless, no big deal since the market is still running or even.  If the market runs up, I more than offset the few hundred bucks I spent on the hedge with my trading portfolio long gains (not to mention my 401K and IRA accounts with are much larger in magnitude and always long).  If the market stays flat, my market neutral strategy performs optimally in the trading account.  If the market dips, I make money on the hedge and buy more stock later.  This has been a tried and true strategy I’ve employed for years.  While my timing could always be better (imagine if I shorted Financials throughout 2008?), it’s nice to have some added flexibility and alternatives when the market tanks rather than just watching in horror as the market devours your portfolio.
The final consideration here is that I don’t want to throw a bunch of money out the window every month hedging against something that may never make me money.

Puts vs. Put Spreads

The most simple way to hedge against a broad market decline would have been to simply buy put options on the S&P500 ETF (SPY).  In the past, I’d been a a big fan of Selling Options for Income when they were expensive because volatility was so high.  Now, with volatility dropping through the floor (investors are surprisingly complacent which makes me nervous!), options are cheap, so I’m a buyer.  Regardless, with SPY priced at about $117 per share, an underlying put option at the money with May expiry would cost about $300.  What I’m looking for is a to spend a bit less money and capitalize more substantially on a mild decline or 5% ore more in the next month or two.

So, what I did was to buy an option slightly out of the money at $115, but then sell another one even further out of the money at $110.  Why?  Well, by selling the 110, that partially offsets the cash outlay to buy the 115 put and increases my ROI for a mild decline. 

Here’s the transaction:

Buy 3 SPY 115 May expiry @ 1.98
Sell 3 SPY 110 May expiry @ 0.93

That transaction had a “spread” of 1.05 each.  So,

1.05*3*100 = $315 Cash Outlay

My max gain would be the difference of 5 bucks on each position

(115-110)*3*100 = $1500

So, my Max ROI would be a 376% Gain

What Happens if the Market Moves up and SPY is over $115 at May expiry? The position expires worthless and I lose the $315 outlay.  Chances are the rest of my portfolio will have moved well over $315 in the upwards direction in that case.
What Happens if the Market Completely Crashes? The one downside here is I capped my gains when SPY hits $110, so the SPY tanks to say, $90, I still just get the $1500.  While I might be disappointed that I capped my gain, at least I’ll have had something – and I can use this $1500 to go pick up some new Apple shares or the next IMAX or whatever, at a significant discount from where it’s trading today.

Are Stock Options For You?

While many view options trading as complex and high risk, it can actually be relatively simple and low risk if you actually take the time to understand the fundamentals, what the possible outcomes will be and ensure that you understand and are accepting of your maximum loss.

If looking to get started, one of the best options-oriented online brokers is now offering an awesome deal.  You can even start off with a $100 Signup Bonus at OptionsXpress with as little as $500 to fund the account.

You're Not Following Darwin's RSS? Check out Why You Have to Subscribe to Darwin's Finance!

If you enjoyed this post, you can get free updates through RSS Feed or via Email whenever a new post is published. Rest assured that you can unsubscribe at any time via the automated system and your information will not be sold, archived or utilized for any other "nefarious" purposes.

{ 2 trackbacks }

High Yield ETF Inflows are Outrageous - How Long Can This Continue?
April 14, 2010 at 10:11 pm
links for 2010-06-01 // Aaron Gladders
June 1, 2010 at 9:34 pm

{ 1 comment }

1 Mark Wolfinger April 1, 2010 at 9:06 am

“options are cheap, so I’m a buyer”

Be very careful. Yes, options are cheap compared to where they have been priced over the past year. But they are still priced much higher than the realized market volatility.

In simple terms, that means: recent option buyers have not seen the volatility they paid for. That means the options turned out to been expensive.

I know it’s not proper to plug my blog, but it is devoted to the options rookie, and Darwin and I both want you to get a good education before trading options.
Options for Rookies.

Darwin Reply:

@Mark Wolfinger, Yes, good point Mark, as volatility continues to decline, any historical options “buyers” didn’t get a good bargain. I should focus on “comparatively”, they are cheap since the VIX was double/triple where it’s at now just several months back.

Comments on this entry are closed.