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Options Theory: Protective Put Management

December 31, 2020

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The topic of portfolio protection is vast. Just think of all the questions surrounding it.

Do I need portfolio protection?

If so, how do I buy it?

What’s the ticker symbol I purchase it on?

Which put strike price do I buy?

How many of them do I need?

What do I do if the market goes up?

What do I do if the market goes sideways?

What do I do if the market crashes and my insurance balloons in value?

And those are just the first handful of queries that come to mind. A big part of the reason we created the Bear Market Survival Guide is to lay out all the answers. Right now, the premium system is on sale for 50% off, so if you’ve been on the fence about purchasing it, consider this your nudge.

Let’s address a few answers in today’s blog for those that are not yet ready to purchase the whole enchilada. I’ll begin by riddling off a few quick responses, and then we’ll dig slightly deeper into managing the protection.

Question: Do I need portfolio protection?

Answer: Only if you own a long-term stock portfolio that lacks stop losses and will continue to suffer if the market undergoes a correction/bear market. In other words, if you have a handful of shorter-term trades that will stop out relatively quickly if the market tanks, then don’t worry about portfolio protection.

Question: How do I buy? Which ticker? What strike?

I suggest acquiring put options on a broad-based index such as SPX or RUT. You can obviously use their ETF equivalents as well (SPY/IWM). My default approach is to buy 10% OTM to reduce the overall trade cost. The duration depends on how long you need the insurance. For long-term positions, I suggest one-year.

Question: How many of them do I need?

One for every 100 beta-weighted deltas of exposure your portfolio has. For instance, if my beta weighted SPY delta is around 300, then I would purchase 3 SPY puts to protect.

Trade Management

The final three inquiries revolve around trade management if the market rises, stagnates, or falls.

Circumstances vary, but I’m going to assume we always want to own insurance to reduce volatility and buffer the downside. With that in mind, here’s how you might tackle the three scenarios.

Prices Rise

I don’t want to micromanage the portfolio insurance. Thus, we need a pretty good increase before I’d adjust the insurance. For SPY, my rule of thumb is to roll up the put once prices rise 8% to 10%. That means if SPY was originally at $100 and I purchased the 90 strike put, I would roll up the put from 90 to 100 once SPY climbed to $108 or $110.

Prices Stagnate

The reason I suggest buying one-year puts is to minimize time decay. But once six to eight months pass, you’re now holding a six to four-month put. Time decay will be picking up, and the daily toll of owning insurance will increase. At that point, I would roll-out to re-establish the put one-year out in time.

Prices Fall

This is the trickiest of the three situations. And there isn’t one right answer. Rather, I have three suggested tactics.

First, if you’re feeling lucky and think markets have bottomed, then take profits on the put and settle in for the market recovery. Once prices have risen back toward their previous peak, you could re-buy the insurance. Of course, the risk is that you exit the insurance too early, and the market proceeds to fall further – this time without anything protecting your behind.

Second, suppose prices fall 10% to 30%, and your put is now ITM and worth a great deal more than you bought it for. Instead of selling it and not owning any insurance, how about rolling down the put to a lower strike. That is, sell to close the expensive ITM put and replace it with a cheaper OTM put.

You still own some insurance (albeit less than you did), but if prices recover, you won’t give back near as many gains.

The third one is the most complicated. It’s known as “rolling to a vertical.” Once prices have dropped far enough and you think a bottom is close, sell a lower strike put against the one you own to convert your position from a long put to a bear put spread. It’s similar to the compromise from tactic two above. You still own insurance, but you’ve drastically cut the cost by the amount of premium received from the short put.

With this technique you also won’t give back gains as fast when prices rebound.

The devil’s in the details on most of these ideas, but this article should serve as a good starting point.

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