Use this customized option collar to protect yourself heading into 2016 while retaining upside profit potential.

The major indices have fully recovered the August September sell-offs but it has come with large, spasmodic day-to-day reversals and built on a just a handful of large capitalization outperformers such as Facebook (FB) and Alphabet (GOOGL). This lack of trend, narrowness market breadth and inability of the SPY to take out the summer highs at $212 level have many wondering if deeper correction is coming in 2016.

The desire to protect profits prompted this recent query from an 20K Portfolio/Option Wizard subscriber to ask about hedging.

Steve, clearly you attempt to keep your options portfolio delta neutral. I assume that most of your suggestions can be utilized independently of your current portfolio. I recognize that you do quite reasonably give suggestions to individuals who have followed previous suggestions. Do you ever discuss ways of hedging one’s own portfolio in this way? Or is that not so important for a retail trader? –Louis.

It is somewhat true that the portfolio is constructed of individual positions that have their own internal hedges (such as spreads) and I will then frequently use options on the Spyder Trust (SPY), typically the purchase of puts or put spreads.

With the recent run stocks have had let’s take a look at how this concept can be applied to a less active and basically long or bullish oriented portfolio.

How Much Protection & For How Long?

Buying put options does offer the most complete and probably efficient way to hedge a position, but it comes at a cost. And that cost, as with all insurance policies, will be a function of the amount of protection and its duration.

The main items to consider when choosing put protection — whether for an individual stock or a broad equity portfolio — are:

1. What magnitude of a decline is expected?

2. At what level of the decline do you want the position to be fully hedged or protected?

3. For what length of time do you want the protection in place?

Answering these questions will help you determine the appropriate number of puts to buy at a given strike with a certain expiration date. By using the basic applications of the delta, in wich an at-the-money option is expected to move 0.50 for every $1 unit price move in the underlying security, one can begin to assess how much and at what levels and cost protection can be purchased.

A great tool can be found at SchaeffersResearch. Its portfolio calculator lets you play around with various levels of put protection for a portfolio of stocks representative of the S&P 100 Index.

Combination Approach

Let’s you have a $100,000 portfolio that is benchmarked to the S&P 500 Index or a position equivalent to owning 480 shares of the SPY. You want to establish protection to carry you through the first few months of the year which will include Q1 earnings report that could set the tone of trend for the year, I’d suggesting  using a combination of spreads.

For example, 3-step approach, using SPY options to create portfolio protection:

1. Use a spread of closer to-the-money strikes – such as buying the March $200 puts and selling the March $180 puts. Such a spread could be bought for around $2.50 net debit. For a $100,000 portfolio, purchasing about 75 of these might provide reasonable protection. But because we’re protecting it in 2 other ways (read on), buying 20 spreads should suffice.
2. The next step is sell a call spread for a credit to help finance the cost of the put spread. Basically, you are creating a collar.

But I would put a small twist and sell a call spread with a nearer dated expiration. This accomplishes two things; 1) it gets time decay in your favor 2) It provides more flexibility to adjust by either rolling out (up or down) to collect additional premium or simply remove and open up the upside profit potential if the market starts trending to a new leg higher.

My suggestion would be to sell the January $212 calls and buying the January 218 calls. This call spread can garner about a $1.50 net credit. Remember: As a spread, this won’t limit your upside as once SPY climbs above the $218 level you become outright long again. You could probably sell up to about 40 of these spreads. Be aware there’s a “dead zone”; if SPY is between 215 and 225, then you’ll lose $3.50 on this position. But I assume you’d be making money if the SPY rallied another 6% from the current $209 levels. You can use higher strikes or sell fewer spreads to align with your risk profile.

These two pieces, a contract March put spread with contracts January call spread on a 1×2 basis would be done for a $0.50 net credit or collect $1,000 in premium for a 15 x 40 contract position.

3. The last step is to use the proceeds of the call spreads to buy some near term out-of-the-money puts to provide low cost disaster protection. For example, the $1,000 proceeds or net credit from the collar could finance the purchase of about 15 of the February $175 puts. Those OTM puts give you outright disaster protection, should a severe correction commence with the start of 2016.

Here is what the risk/reward profile of such a modified collar would look like:

You can see the temporary loss that would be registered if SPY was between $220-$230 at the January expiration. But again, we have a dynamic options position with the ability to adjust and roll as time and price dictates.

All told you have no net outlay – note there would approximately $8,000 of additional margin required – to not only fully protect your portfolio but also leave room for upside profit potential.

This is just a loose construct – and you can play around with the numbers – but I think the best hedges will ultimately involve more than simply picking one strike or one expiration date.

The upshot is; be forward thinking and use the flexibility of options to customize your portfolio’s risk profile so it aligns with both your outlook and temperament.