Category Archives: Options for portfolio protection
The Stock Repair Strategy
Have you ever bought a stock and seen it go down? In need of stock repair? One way to try to recover is use the stock repair strategy. It can be used to lower your break-even point. What you do is sell a two by one call ratio spread on the underlying stock to adjust your cost basis lower. The trade can be put on for a small credit or a break even price. For example, our investor buys 200 XYZ at $27.50 for a total investment of $5,500 and it’s now at $20, or worth $4,000. She would sell four $25 calls for $0.50 each and collect $200, then use those funds to buy two $22.50 calls for $1. At no cost, the break-even point is now lowered to $25. If XYZ rises to $25 at expiration, the $22.50 calls would be worth $2.50 each or $500 and the $25 calls would expire worthless. So the 200 XYZ would be worth $5,000 and the two calls would be worth $500 for a total value of $5,500. The breakeven point has been lowered from the initial purchase price of $27.50 to $25.00 at no cost.
The equity collar consists of a short call and a long put married to
a position in an underlying investment.It is also referred to as a collar option. It is especially useful for owners of concentrated equity positions. Say, for example you are employed at ABC Corp and are nearing retirement and been fortunate enough to accumulate 20,000 shares of ABC which is now at $50 per share. The million dollars that you have in ABC is a substantial portion of your net worth. Retirement is two years away and you can’t sleep at night because a decline in the price of ABC could seriously impact your ability to retire. At no cost you can sell call options on your position and use the proceeds from the call options to purchase put options. You can evaluate a wide range of strikes to determine which combination is best for your individual situation. You can sell at the money calls and buy at the money puts in which case you are basically locking in the price of ABC and saying that you are content with that price level and are willing to
sacrifice further upside gain in order to prevent any loss. You can also use a
call spread instead of just a covered call, that way if the stock makes a large
move to the upside you’ll participate in any gain above that highest strike of
the spread. You can use it as an income producing strategy by selling calls
slightly out of the money and buying puts further out of the money for a net
credit. That way you are retaining some of the call income for your use and you
are setting the maximum downside risk at a pre-determined level that you are
comfortable with. Investors who decide to collar an entire position are never
happy if they the price rise substantially after the collar is put on and they
don’t participate in that gain. There are a couple of ways to leave some room
for upside gain and still have some downside protection. One is simply to only
collar a portion of the position. With the 20,000 shares of ABC for example, we
could decide to only collar 10,000 shares that would leave 10,000 subject to
market risk and 10,000 protected from price decline. The ratio chosen depends
on the financial goals and emotional makeup of the investor. The other method
for participating in an increase and still have a collar is to use a call
spread instead of just a covered call. If ABC is at 50 for example we could
sell the 55 call, buy the 45 put and buy the 60 calls. If ABC makes a large
move, such as a takeover of the devepoplemnt of an exciting new product, we’ll
participate in the upside gain above $60. When using call spreads ratios can
also be employed, the options don’t have to be in a one to one ratio. For example
with the 20,000 shares you could sell 200 of the 55 calls, buy 200 of the 45
puts and buy 100 of the 60 calls for the upside gain potential. The
combinations are virtually limitless and the ideal combination depends on the
investor’s unique situation. If exchange trade vanilla options don’t provide
the strike prices and expirations that match your goals, this is an area where
using the FLEX options can make a lot of sense. What I do as an RIA is
thoroughly evaluate our client’s needs and situation, then run calculations on
the various option combinations to see what will work best for each investors
unique situation. The proprietary calculations that we use involve solving
equations in multiple variables. We’ll consider the overall position delta, gamma,
and theta. If the investor’s goal is to be delta neutral at the onset we’ll
sell a 50 delta call and buy a 50 delta put. If the position is put on for a
net credit, the delta will work in our favor and provide some income. If put on
for a net debit, the theta represents the daily expense of maintaining the
The long put option is similar to the long call option in that the
investor has the right but not the obligation to exercise. The purchaser of a
put option has the right to sell the underlying at the strike price on or before the expiration date in the case of an American style option or on the expiration
date if the investor owns a European style option. The owner of a put will
participate in the downside of the market with risk limited to the premium or
price paid for the put contract. Puts can be purchased to profit from a price
decline in a stock, an index or a commodity. For example if you own an all
stock portfolio with 20 holdings and are concerned about a general price
decline in the market, you could purchase a put on a broad based index that
would increase in value if the market declines. The tactical option investor who
purchases a put that is not used to hedge a portfolio against a market decline
is considering a couple of different factors. The first is an analysis of the
underlying to determine if it is overpriced or not. There are a variety of
fundamental research sources that can be used to help determine if a stock or
an index may be overvalued. Once we have determined some overvalued investments to consider, then we study the charts and consider the momentum of the investment. An individual stock or a commodity for example may seem to be overvalued but its price momentum can continue upwards for long periods of time and they can become even more overvalued. The application of some technical analysis can find investments that are overvalued and have some downward price momentum. A moving average crossover can be a good simple tool to apply. The third step is to indentify underpriced put options. You can find an overvalued stock in a downtrend and if you pay too much for the option it may not produce a profit. To locate undervalued options you need to consider the historical volatility of the stock, the implied volatility of the option and study the history of the implied volatility to see where the implied volatility is relative to its long term averages. The difference between a speculator and a
tactical option investor in these types of transactions is that the tactical
option investor will have a fundamental opinion on the underlying investment,
apply some technical analysis to see if the price momentum is favorable and
find a reasonably priced option. The tactical option investor will also buy an
option with sufficient time remaining in the contract for the price movement to
develop. Many option speculators experience failure because they don’t take the time to properly analyze these three steps and they trade in too short of a
time frame. There is much work to be done when taking directional trades with
options, the markets are very efficient and arbitrage opportunities rarely
exist. Using a long put to hedge a portfoliois different because the investor chooses the option contract based on hisunderlying portfolio and is concerned about portfolio protection or insurance. Puts used for portfolio insurance are known as protective puts. Married puts are put options that are tied to a certain number of shares of a specific stock.
Understanding Stock Market Volatility and the New Volatility ETFs.
Volatility in the stock market is what makes investors nervous. Without volatility, though stock prices couldn’t rise. Volatility is defined as the standard deviation of stock returns. It’s the downside volatility of the market that causes fear.
A recent development in the rapidly expanding ETF universe has been the creation of funds that reflect different measures of market volatility. These funds can be an effective hedging tool against portfolio declines when used properly.
The most commonly referred to measure of market volatility is VIX, which is a measure of the implied volatility of option contracts on the S&P 500. The VIX is also known as the “fear index.” The VIX will have a high reading when market participants are fearful and be low when the market is strong and there is a sense of complacency.
There have been numerous academic studies done on using the VIX to hedge equity portfolios. Goldman Sachs did one that concluded that VIX options could be a very effective portfolio management tool for risk reduction.
So how can an individual investor use the VIX for portfolio protection? Not too long ago, an investor would have had to buy and roll call options on the VIX index. This process worked well, but one had to consider the time decay of the options and the term structure. VIX options are based on the VIX futures, so each month’s option series correlates to that month’s futures contract. Some months may be priced higher or lower than another depending on the outlook of market participants. A strategy of rolling call options could be difficult for individual investors to implement effectively.
Today, an investor who wants a hedge and who doesn’t want a short position or an option position with time decay can purchase shares of the volatility ETF, the VXX when it is near the low end of its historical trading range. The VXX can be held indefinitely, just like a mutual fund. Once the VXX position has been purchased, it is held until something happens to the market to increase the volatility. If the market gets spooked by bad earnings reports, poor economic data, or unforeseen global events like natural disasters, war, terrorist attacks, etc, the VIX will spike and profits can be realized from the VXX position which can help to offset declines in a long term portfolio.