If you’ve been following our weekend reports and daily market recaps you’ve no doubt seen the comment that low volatility is a prime time to purchase some portfolio protection. Such a suggestion, though wise and potentially timely, must be placed into context. I see too many of my all-star students sallying forth into put options with nary a thought to if it’s appropriate for their situation. Furthermore, they lack any type of plan regarding which put to purchase and in what quantities. Not to mention how to manage the thing.
Consider today my effort to right all that is wrong in the world.
First, the need for portfolio protection assumes you do indeed have a portfolio.
Revolutionary, I know.
Such a portfolio would need to be net long stocks. One boasting long-term positions which suffer during the reign of those nasty bearish overlords. The exact composition of the account doesn’t much matter. Maybe you’re long a bunch of ETFs. Maybe you own ten different stocks. Maybe you’re selling covered calls along the way, maybe you’re not.
You are to some extent a buy and holder, carrying these positions come rain or shine. That right there is a portfolio well served by heeding the call for protection. On the other hand if you have a few swing trades or short-term option positions then you are a horrible candidate for buying protection. What, pray tell, are you protecting? Are your trades not already protected via proper position sizing and stop losses? If the market tumbles you get stopped out thereby ending your pain. Such a definitive end to loss doesn’t exist for those holding stocks long-term.
Now, supposing you boast the former portfolio which put option and how many do you buy?
We typically suggest buying long-term options, LEAPS as the cool kids call them. That way you have ample time for the dreaded downturn to arrive. They’re harder to predict than meets the eye so having time on your side is a must.
And I know, buying time is expensive. So reduce the cost by purchasing out-of-the-money puts. 10% should do the trick. With the SPY currently trading at $208 you would buy something around the June 2017 187 put. To determine what is 10% OTM I took $208 x 0.90.
You could also use IWM.
How many you purchase is part personal preference, part math. Typically you would buy one put for every 100 shares of SPY owned. I know, I know, you probably don’t own just SPY. So here’s a trick to determine your net exposure. If you’re using ThinkorSwim you could always beta weight your portfolio to SPY and see the net delta. If it’s around 100, congratulations, your portfolio is the theoretical equivalent of owning 100 shares of SPY.
Another shortcut would be to tally up the amount of money you have in all your stock positions. 100 shares of SPY is about $20,800 right now. So if own about $20k worth of stocks (that are somewhat correlated to the SPY) then I’d bet your portfolio behaves similar to 100 shares of SPY.
Bear in mind, owning puts isn’t a panacea. Should the market meander or rally from here you will underperform due to the puts losing value. But, you should still be making money overall. If you bought puts and the market rips 5% and you lose money overall, then, yeah, you position sized wrong.
And if the market plummets you better have a plan in place for how to manage those now profitable puts. Want some ideas? Might I suggest my recent newsletter: I Bought Portfolio Protection, Now What?
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