By Daniel Bustamante, Co-Founder and Lead Coach
When investors in both the retail and institutional space look to purchase insurance and protect portfolios they usually turn to the options markets. The reason being is because it can be easy to quantify what needs to be hedged and build a portfolio that could be classified as “risk-neutral”.
If you are new to options trading, I’ll give a quick introduction to options, before diving into using more advanced options strategies to hedge out portfolios or make returns when markets selloff.
Traditionally, an “option” contract gives the holder the right to buy or sell an asset at a predetermined price within a certain period of time (or by an expiration date).
Note that the holder is not obligated to buy or sell at the predetermined price. He merely has the option to do so if he wishes to. That’s why they’re called options.
There are two kinds of options: Calls and Puts. For this brief overview, we’ll only quickly cover the mechanics of options buying.
What is a Call Option?
A CALL option allows an investor to BUY the underlying asset at a predetermined price, dubbed the “strike price.”
If an investor expects the underlying asset to rise above the strike price before the contract expires, he would purchase a call option.
What is a Put Option?
Purchasing a PUT option gives the buyer the right to SELL an asset at their chosen strike price. If he thinks the market price of an asset will drop below the strike price before the contract expires, he will buy a put option. The purchase price of an option is also called the “premium.” When buying options, the premium is the most you will risk or can possibly lose. The profit from an options trade is the amount the market has gone beyond the strike price minus the premium at the contract expiration.
Let’s say you want to buy a piece of land that is currently worth $100,000. You think it will rise in value to $130,000 one year from now. However, you don’t want to tie up $100,000 for a year.
The seller offers to sell an option contract to you to purchase the land for $100,000 (strike price) one year from now. The seller offers the contract at a $5,000 premium. You agree, pay the $5,000 to the seller, and wait to see if the value rises.
In one year, the land value increases to $130,000. You exercise your right to purchase the land at the agreed price (the strike). You pay the owner the $100,000 contract price, and now you own the land.
Your profit on the land is the current value, $130,000, minus the purchase price (strike) plus the contract premium: $130,000 – ($100,000 + $5,000) = $25,000.
Alternatively, let’s say that in one year, the land falls in value to $80,000. You are not obligated to exercise the contract and decide not to buy the land. Your only loss is the premium paid ($5,000) to the option seller. As you can see, options are a great alternative to play your market ideas with extremely limited risk.
Let’s move on to the most common strategies in protecting portfolios using options in down or high-volatile markets.
Protective puts: The most basic defensive move allowing you to continue holding the stock is the long put, also called the “insurance” put. This is also termed a synthetic long call; in the event, the stock value rises, the overall stock/put long position rises as well. However, a problem with the protective put is that requires payment of the put premium. So, if your basis in the stock is $50 per share and you buy a 50 put and pay a premium of 3 ($300), that means your net basis in stock must rise to $53 per share. So, you need a three-point gain just to break even. For this reason, just buying a protective put leaves a lot to be desired.
Synthetic Short Stock
Synthetic short stock: The second strategy is to create an option-based position that will increase in value point-for-point if and when the stock’s value falls. It consists of one long put and one short call opened at the same strike. The cost of the put is offset by the income from the call. This is a very low-risk position for two reasons. First, the net cost is zero or close to it and, in some instances, even creates a small net credit. Second, if you are trying to protect the stock you own, each synthetic position provides protection for 100 shares.
The put provides downside protection while the short call is covered. If the stock rises, the short call will be exercised; or, to avoid exercise, it can be rolled forward as an on-going covered call. This strategy solves the flaw of the protective put by covering the put’s cost with premium from the short call.
Collars: The collar is similar to synthetic short stock. It involves 100 shares of stock, a long put, and a short call. Usually, the call and put are opened at different strikes so that both are slightly out of the money. If the stock price rises, the call is covered; if the stock price falls, the put grows in value. As the net cost of the two options is at or close to zero, it does not take very much movement for the long put to become profitable. Because the short call is out of the money, time value will fall rapidly as expiration approaches. Your choice is to either close the short call and take a profit, or wait for it to expire worthless.
There are many more methods for playing defensive with options; but as a starting point, every trader needs to be aware of these key strategies.
At StockAbility™, we focus on only trading a few ETF’s and high momentum stocks both on the put and call side when markets sell-off. This ensures we don’t have to spend countless hours screening various charts and finding setups. The most common way investors hedge their stock portfolios is to buy puts on major index ETF’s like $SPY or $QQQ.
We teach this approach, and other simple yet powerful methods to manage your retirement accounts in our WealthAbilities course. You can also register here to attend one of our complimentary StartUp Sessions to learn more from our lead coaches.
All the best,