Suppose like an appropriately paranoid investor you’ve been carrying long put options in your portfolio for protective purposes. Maybe you’ve owned them for months (begrudgingly, I suspect) or maybe your timing was fortuitous, and you scooped them up right before last week’s market crash.
Either way, your foresight and preparation have finally paid off. An official 10% correction has arrived and implied volatility has exploded. Together these twin forces are causing your puts to balloon in value. And thank goodness because the gains are helping to offset some of the losses suffered by your beloved stock holdings.
But what do you do now? Buying puts is easy. It’s nailing the management that separates the men from the boys. So, allow me to offer up a few ideas.
First, there’s no sense in buying put options as portfolio insurance if you don’t learn how to capitalize when a market plunge strikes. While there isn’t one right method for responding to a crash you have to do something.
Suppose you owned 100 shares of IWM at $153 (or a $15,300 portfolio that is the equivalent) and you previously purchased a Dec 2018 $140 put option for $5.50. At the time those puts sat 10% OTM (and cost roughly 3.6% of your portfolio value) but with IWM falling towards $142 last week they were fast approaching ATM.
Let’s say your Dec 2018 $140 puts lifted toward $8.50 providing an unrealized gain of $3.00. One of my favorite ways to adjust profitable puts when the VIX is sky high and the market deeply oversold is to roll them into bear put spreads. All you have to do is sell a lower-strike put in the same expiration against the one you own. In doing so, you bring in premium which reduces your overall cost and risk.
For example, last Thursday when IWM was sitting near $145 you could have sold the Dec 2018 $120 put for $3.80, morphing your trade into a Dec $140/$120 bear put. The $3.80 credit would have reduced your overall position cost from $5.50 to $1.70.
Think of the benefits.
One: You were able to sell a put when option premiums were pumped, capitalizing on the excessive volatility.
Two: The premium received reduced the overall cost of insurance for the year from $5.50 to a mere $1.70. That means if the market were to recover significantly the gains sacrificed in your long $140 put would be partially offset by the profits in the short $120 put.
Three: If the market continues to plunge, you still have protection down to $120. With IWM at $145, that’s another 17% drop. Rolling to the put spread is a more comfortable decision than merely taking profits on your put because you still have some protection if the market remains under pressure.
Timing when to roll your long puts into put spreads comes down to personal preference. I suggest considering doing so when the market drops around 10% or more. The closer you can get to nailing a short-term low in the market (or peak in the VIX) when selling the lower-strike put, the better.
So far, Friday morning would have been the ideal entry. That way all those profits you gave back in your long $140 put over the past two trading sessions would have been partially offset by gains in the short $120 put.
Here’s a risk graph showing your insurance position post-adjustment. Note how in exchange for dropping the risk from $5.50 to $1.70, we’ve capped our potential profit.
Two other ideas on managing near what you think might be a market bottom are selling your put to take profits or rolling it down to pull capital out of the trade.