Tales of a Technician: A Trick for Financing Portfolio Protection
March 2, 2016
Last update: August 2021
In Tagging the Golden Goose: A Lesson in Portfolio Protection we investigated the choices facing stock investors in search of protection. The whiz-bang idea for paying for the insurance policy (LEAPS puts) was to sell OTM call options every month or two. Those unexcited about the idea, but still open to additional strategies for curbing the onerous cost of buying LEAPS puts will be happy to know I have another tactic worth consideration.
Let’s recap the situation:
First: you have $100K invested in the S&P 500 via SPY. With SPY perched at $193.50 you own around 500 shares.
Second: To acquire protection you purchased five Jan 2017 175 strike put options for $1,000 apiece. The puts sit 10% OTM and provide protection for one year. All told you’re paying $5,000 or about 5% of your portfolio for the protection. As mentioned in the newsletter I’m not a fan of paying 5% of your portfolio to acquire puts every year. The cost is too burdensome.
Instead of selling covered calls to partially finance the put purchase, what else could we do? How about selling further OTM Jan 2017 puts? In other words, buy a put spread instead of straight puts. For example, what if we bought the Jan 2017 175 put for $10.00 while selling the Jan 145 put for $4.00.
The $4.00 received from the short put reduces the protection cost from $1,000 to $600 per contract. That’s a 40% reduction. The catch is that your protection now has a limit. The long 175 put locks in the right to sell your SPY shares at $175 affording protection down until the short put at $145. Essentially once SPY falls below $145 your insurance policy runs out and you’re back to full exposure. Here’s another way to think about it. The $175 put is 10% OTM so once the SPY drops 10% or more your protection kicks-in. The short 145 puts sits 25% OTM so if the market somehow drops more than 25% the protection disappears.
Risk graphs come in handy to illustrate the difference. First, checkout the long SPY position with the LEAPS put for protection. At expiration the put kicks-in at $175 to minimize any further loss. The downside is you now have to make $10 per share on the stock just to pay for the insurance.
The next risk graph shows the long SPY position with a Jan 175/145 put spread purchased for $6.00
Just like the prior position the long put kicks-in at $175 to eliminate any further loss from that point forward. Unlike the prior position, however, the protection only lasts until $145. At that point the short 145 put offsets the long put and you’re back to your straight long SPY position. What’s the upside for cutting off the protection like that? We received $4.00 from the short 145 put which cut the cost of our yearly insurance policy from $10 to $6 per share.
If you want the protection to go further, then don’t sell the 145 put. Maybe sell the Jan 135 strike instead. That won’t cut off the protection provided by the put spread until SPY has fallen 30%. Bear in mind this option includes a tradeoff. The 135 put is only worth $2.80, so it only reduces the portfolio protection to $7.20 from $10.00 instead of reducing it to $6.00. In the end you have to decide which lower strike put provides the optimal trade-off between cost and protection.
Given how uncommon it is for the SPY to fall 25% to 30% I certainly wouldn’t mind losing protection at that point in exchange for a 30% to 40% reduction to the annual cost of the insurance.
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The clarity in this presentation is absolutely excellent and is exactly what I needed to broaden my understanding of LEAPS Puts.
Thank you.
That’s why they pay me the big bucks:)
Very well illustrated points. That demonstrates how creative you can get with options!
You are a very valuable asset to Tackle Trading Tyler. I hope you do get paid the big bucks. Thank you.
I still am long one Jan 2017 180 Spy Put purchased December 2016 for $8.54. I failed to take advantage of selling it when the VIX was abnormally high. Now I am just about even on the purchase with an $11.00 loss. Thanks in advance for any insights on adjustments I should be thinking about in this case.
Thanks for sharing Bonnie. I’ll address ideas for managing portfolio protection in a future post (probably a newsletter as it merits a more in-depth discussion).
Nicholas- you flatter me. I knew I liked you.
Great post! How many days before expiry would you consider rolling the options? Would it be around 60,50,40,30 days out as that would be the time that theta would eat away at those long puts?
Clayton,
If I started out buying a one year LEAPS put, I’d probably roll it when it had maybe 3 or 4 months of time remaining. I wouldn’t even let it get to 60 days. That way you’re warding off theta well before he becomes a big nuisance. Glad you liked the post.
Tyler, great article. I’m your fan.
I too think that paying 5% my portfolio to acquire puts every year is too burdensome. I’ve been studying how to hedge my stock positions and I can’t seem to find an answer. Not THE answer, just one that works.
From an educational perspective, what do you think should be my approach on this study? On a portfolio that is the size of about ≈ 59 SPY shares. I’ve been testing to buy ≈ 365 DTE insurance allocating 1% to 5% of the total amount. 1% doesn’t hedge anything and I prefer buying no puts. On the other hand, 5% hedges pretty well but it’s too much, considering that corrections of about 20-30% are not so common. And it also completely kills my Theta.
So, again, I’d like to learn from you, from an educational perspective, what do you think should be my approach on this study?
Cheers,
– Christian Sisson
Christian. Good question.
Instead of looking at it in percentages, let’s talk number of contracts. Typically you buy one put for every 100 deltas you want to hedge. So to hedge a 59 SPY delta portfolio your only real option is to buy one put. That’s it. If that’s 1% of your portfolio, then it’s 1%. If it’s 5%, then it’s 5%. You can’t really choose what percent to allocate because you only have ONE choice – buy a single contract put or don’t.
I’m also assuming this is a passive account where you’re riding the market down 10% to 30% without getting stopped out. That way your deltas remain somewhat constant. For people who just have a handful of swing trades that are getting stopped out on a 5% drop, the idea of buying puts as protection isn’t really relevant. Make sense?
Thanks for the reply, Tyler!
Actually, 50% of this portfolio is dedicated to cashflow trades and the other half is like a sitting-on-my-hand stock portfolio, i.e. not touching it. The idea is using the cashflow part to buy more shares for the other half, which in fact is being done on a regular basis.
I was thinking about not buying puts at all for the exact reasons you mentioned. In fact I didn’t, prior to this recent melt down.
Sorry for not mentioning the 50-50% split. My fault.
Your feedback helped me a lot, Tyler.
I want to take this opportunity to share a series of papers I’ve read recently. You can find them here: https://www.universa.net/research.html. They’re called “Safe Haven Investing” series, divided in 4 Parts. The other papers are also great, but I really liked the Safe Haven series.
Cheers!
cool. Thanks for sharing. I’ll take a look!