In times of market turmoil like we’re experiencing right now, many traders and investors turn to the options markets to protect accumulated profits in the event of steep declines.
As you might expect, options tend to get fairly expensive in implied volatility terms when big down moves appear possible, so simply buying puts on individual holdings or on the broad market ETFs will cost more than it ordinarily would during more sanguine conditions.
Currently, the CBOE Volatility Index is considerably higher than its multi-year average of 12-13%. After Wednesday’s steady fall in the major indexes, the VIX is well above 20% - indicating that demand for protective options has risen dramatically.
To protect all or part of a diversified portfolio from future declines, the right trade would involve simultaneously buying and selling options to avoid paying some of the excess premiums that the options markets now command.
The answer is the “Collar.”
The trade involves buying a put below the current value of the market and also selling a call above the market price to offset the cost of that put.
This trade is also sometimes referred to in professional trading as a “risk reversal.”
You give up some of the profit opportunity to the upside, while protecting the portfolio from severe declines.
You could buy protection on individual stocks, but with the increasing popularity of indexed investing, big-cap stocks are increasingly correlated, so it probably makes more sense to make a single trade using options on broad market ETFs which tend to closely replicate an balanced individual portfolio.
Here is the payoff diagram if you own 100 shares of SPY:
As you’d expect, it makes and loses money in a linear fashion as the S&P 500 moves up and down.
Here’s what it looks like if you protect the position by buying one September 270 put for $3 and selling one September 300 call for $1:
If SPY rises between now and expiration, your profits are capped at prices above $300/share, but if the index declines, your losses are limited to $15. You are indifferent at every price below $270/share.
Because downside puts usually trade at higher implied volatilities than upside calls, you would incur a debit of $2.00 per spread, but you are also insulated from severe moves lower.
In an environment in which news events and interest rate moves have been causing significant uncertainty for the major indexes, you might find that a reasonable price for protection – and a good night’s sleep.
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