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I Bought Portfolio Protection…Now What?

April 3, 2016

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No highfalutin intro on this one. We’re getting straight down to business: Portfolio Protection.

As I’ve circled round the topic of portfolio protection (see here and here) it’s become apparent that what we all need is to have a nice little chat on how the heck to manage the protection once it’s in place. Any two-bit shmuck can buy a put option for his beloved stock portfolio. But only a top rate trader knows how to manage the insurance policy to maximize efficiency.

I’ve witnessed enough traders diligently scoop up LEAPS puts in preparation for the next bear market, only to bungle the management when the stock swoon strikes. Enough is enough I say. Today is the day we layout a game plan for exactly how to manage portfolio protection.

I Bought Portfolio Protection...Now What?

Suppose we have $100K invested in the S&P 500 via SPY. Or, if that’s too clean for you, suppose we have $100K invested in a variety of stocks that boast a strong correlation with the SPY. How would you know that? Listen up and I shall reveal the mystery. As I type (March 11th) the SPY is perched at $203 following a holy-freaking-cow rally. A hundred grand would buy you a cool 500 shares. Think of your position as 500 SPY deltas. Now, if you had a potpourri of various stock positions in your portfolio you could use the magic beta weighting tool in ThinkorSwim to ascertain your net exposure in terms of SPY deltas. We’d call that your SPY beta weighted delta. If your aggregate portfolio’s beta weighted delta came out to 500, well, then your account is effectively the equivalent of 500 shares of SPY.

Got it? The following risk graph illustrates your long SPY position. At $203 your SPY position value has $101,500 at risk while the reward is unlimited.

Long $SPY risk graph

Now, suppose the 15% round trip drop-n-pop that greeted us in the first quarter has your knickers in a twist. The last thing you want to experience is another plunge into the abyss sans protection. So like a good little trader you buy five 10% OTM LEAPS put options, one for every 100 shares of SPY you own.

Let’s say you buy five of the March 2017 182 strike puts currently trading for $9. The 182 strike is 10% OTM which reduces the cost a fair bit while March 2017 sits one year away providing a full 52-weeks of protection just in case it’s months before the next correction comes. All told, five contracts at $9 apiece means you’re paying $45, or $4,500 for one year worth of protection. That’s 4.5% of your total portfolio value.

Your new position is illustrated below. Take note that your risk below $182 is eliminated due to the long put options. Your max loss now stands at a mere $15,000.


Now, the hard part begins. Do you hold the puts until March 2017? Do you roll them early? What if the market drops 10% or 20%? What then? Let’s walk through a few potential scenarios.

  1. Scenario #1: S&P 500 ($SPY) Rises
  2. Scenario #2: S&P 500 ($SPY) Stagnates
  3. Scenario #3: S&P 500 ($SPY) Drops

Scenario #1: S&P 500 ($SPY) Rises

Suppose SPY rises 10% over the next six months to $223. On the bright side the $20 rise delivers a $10,000 gain to your position. Yay! If you want to be a downer you can kick yourself for buying protection you didn’t end up needing. But, really, that’s kind of a crap perspective. Do you beat your head against a wall every month because you failed to wreck your car? Dang! My car insurance wasted, again!

A $20 rise over six months would reduce the value of the 182 puts from $9 to about $1. So you’d be looking at an $8 loss per contract, or $3,200 total. Unfortunately, the insurance loss would pare your $10,000 profit down to $6,800. Such is the profit reduction baggage that goes along with insurance. The risk graph of your position with the 10% gain is shown below (IGNORE the 20% note in the graph. That right there is a mistake. I make one every couple of years).

$SPY Rises TOS risk graph

So, what now?

Since the puts now sit almost 20% OTM and only have six months remaining the time for adjustment is nigh. Rolling up probably makes the most sense here. Sell to close the March 2017 182 puts for $1 and buy to open the Jan 2018 201 puts for $9.70. The roll will cost $8.70 and brings your insurance back to 10% OTM while extending the duration until Jan 2018. Really, if SPY kept flying into the wild blue yonder you could simply keep rolling up the puts every time it notched another 5% to 10% gain. The principle drawback to always carrying the protection is the onerous cost. As mentioned previously, I like the idea of tactical put protection purchases as opposed to always carrying them.

Scenario #2: S&P 500 ($SPY) Stagnates

Yet another potential outcome would be a neutral market. Maybe SPY meanders sideways over the year frustrating bulls and bears alike. What then? Well, obviously your put would lose value due to the inescapable erosion of time decay. Let’s say eight months pass and the SPY is still perched at $203. Your March 2017 182 put now has a mere four months remaining and has dropped in value from $9 to $2.50. Your five contract put position has now lost $3,250. Welcome to the frustrating part of insurance. You’ve now lost roughly 3.25% of your total account value. That right there is the cost of protection, friends.

$SPY Stagnates TOS risk graph

So, what now?

Time to roll out if you want to maintain the protection going forward. With four months remaining (it’s now Nov 2016 and you own a Mar 2017 put) the 182 put is going to quickly lose that last $2.50 of value. Buy it back and roll out to maybe the Jan 2018 185 put (a 182 strike isn’t available). Since SPY is still at $203, the 185 strike sits about 10% OTM making it an appropriate strike price to use. The new put would cost about $10.50 at that point so the net debit to roll would be $8 ($10.50 – $2.50).

Scenario #3: S&P 500 ($SPY) Drops

The final outcome is the one that is arguably the most gratifying for protection buyers. Sure, your overall portfolio value is dropping, but hey, you feel like a rock star for buying insurance before the crash.

You stud!

Sell-offs in excess of 20% are rare so let’s assume the SPY falls 15% from $203 to $173 over the next four months. Here’s what the long 500 SPY position without protection would look like:

$SPY Drops TOS risk graph

Here’s the long 500 SPY position with the five March 182 protective puts:

$SPY with puts TOS risk graph

The puts reduced your loss by about $4,700 or roughly 30%. Not bad. Were the SPY to really fall out of bed here you can see the rate of loss would decelerate dramatically at this point as the puts move deep enough in-the-money to fully hedge your long stock position.

Deciding how to manage the trade with a large down move in the SPY is perhaps the trickiest of all the potential outcomes. The market will undoubtedly be in a sharp downtrend, ugly as sin. Fear of further selling will make it extremely tempting to hold onto the puts just in case the 15% drop morphs into a 25% one, or worse. And yet, if you never take profits or adjust your position after corrections you’ll see the paper profits in the puts dissipate once the market recovery takes root.

I’m an advocate of doing something at this point. Which action you take depends on which tradeoffs you find most attractive. Here are my top three suggestions in no particular order:

  1. Trade Adjustment #1: Sell the puts
  2. Trade Adjustment #2: Roll down
  3. Trade Adjustment #3: Roll to a Vertical Spread

Trade Adjustment #1: Sell the puts

Take a moment to thank your puts for their diligence in hedging your position. Thank them for the memories and then kick ‘em to the curb. With the market now 15% – or 20%, 25%, however much it’s fallen – it’s decidedly less risky to be long SPY, not more. Maybe at this point you’re willing to face the future sans protection since the odds of the SPY being higher a year or two out are much higher after a downturn.

Sell to close the puts and settle in for the next recovery. It will come … sometime.

Trade Adjustment #2: Roll Down

Perhaps the idea of parting with your beloved puts is too hard to bear. What if the market keeps selling off? I can’t part with my protection now, you reason. The world is on fire! Ok. Fine. But how about we at least take some money off the table, eh? With the SPY having fallen to $173 your 182 puts have moved from sitting well out-of-the-money to in-the-money. Their value has ballooned from $9 to over $18, doubling the capital you have committed to the hedge.

To harvest some of the gain we could roll down. That is, sell to close the 182 puts and buy to open a lower strike price, say, the 170 put. If there’s enough time remaining to March 2017 expiration you could remain in the same expiration cycle. If not, you could roll out to extend duration. Let’s assume we stick with March 2017. With the SPY at $173 you could sell the 182 puts for $18 while buying the 170 puts for $11. The roll could be initiated for a net credit of $7. That $7 represents the amount of capital you’re extracting from the position.

Since you originally purchased the puts for $9, the $7 credit received all but pays for the protection. At this point even if the market rebounds significantly and your puts expire worthless you’ll only be out $2 all-in.

One drawback to rolling down is that you’re selling an ITM put to buy an ATM or slightly OTM put which is going to possess a monster amount of extrinsic value due to the spike in volatility undoubtedly seen during the stock crash. It’s a necessary evil, no doubt, but maybe there’s an alternate technique to capitalizing on the volatility spike instead of suffering from it. That’s our next, and final, technique.

Trade Adjustment #3: Roll to a Vertical Spread

This is getting lengthy, but stick with me, we’re on the home stretch. The final idea for managing your profitable put protection is rolling to a vertical spread. When the SPY is crashing and volatility is flying, premiums are expensive. It’s mighty attractive to sell options at that point.

So do it.

Sell a lower strike put against the March 2017 182 puts you own. It will turn your trade into a bear put spread. That way if the market stagnates or rebounds, the short put will hedge whatever you give back in your profitable 182 put. Remember, after you purchased the March 2017 puts, four months have passed and the SPY has fallen to $173. Your long puts have increased from $9 to $18 giving you an unrealized gain of $9.

What if you sold the March 2017 160 puts for $10? The $10 received would more than pay for the 182 puts creating a March 182/160 bear put for a $1 net credit. Remember, bear puts are debit spreads where the debit paid is the risk. Since we were able to roll into this put spread for a credit we have ZERO risk. Even if the SPY were to magically recover back up to our $203 entry price over the coming months we won’t lose anything on the protection. In fact, we’ve locked in a minimum gain of $1 per spread.

And we own five of them. So that’s $500 minimum reward at this point.

That should give you protection seekers enough to chew on at this point. Read through this newsletter a time or two and consider implementing whichever techniques seem the most attractive during the next market swoon.

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5 Replies to “I Bought Portfolio Protection…Now What?”

  1. KEITHGIUNTA says:

    Thanks, Tyler, for the erudite exposition. Of course you realize that my head is now exploding!!

  2. DaveKaufmann says:

    Valuable advice! Thanks Tyler

  3. BONNIELEAHY says:

    Exactly the understanding I needed. Thank you!

  4. Sundar says:

    Timely article, Tyler. Will require me to re-read at least 3 times to start understanding the scenario and follow up action suggested. You are the man for the moment. Many thanks.

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