Options Trading: 4 Ways to Protect Your Portfolio
By: Steve Smith
Amidst heavy saber rattling over tariffs and a seeming slowdown in global growth, earnings season is about to kick off. We have big banks such as JPM and BAC reporting on Friday and Netflix set to post results on Monday.
This will be the real acid test for the bull market. Will companies post sufficient bottom line growth to justify the recent multiple expansion being awarded the market?
Once we see the specific price action and news that could lead to a significant sell off.
Here are four ways to protect your portfolio heading into earnings season.
For the past few days, the stock market has been experiencing wide price swings, with alternating up and down days and expanding volatility. On Tuesday, the market registered a large intraday reversal of over 2% trading range. This type of action usually precedes a turn in market trends.
Indeed, the VVIX or “volatility of the volatility index,” has been trending sharply higher. The VVIX typically ranges between 60-100. In the past few days, the 21-day average (approximately 1 month) of the VVIX reached a level of 110. Since the inception of the VVIX in 2007, this is just the 5th time its 21-day moving average has gotten that high. The other 4 occurred during times of legitimate turmoil.
Now I don’t want to be all doom and gloom. Nor am I suggesting you rush out and sell your stock holdings. But it’s against this backdrop that I’d like you to consider your options for establishing downside portfolio protection. Let’s look at four ways to use options trading to guard against, or even benefit from, a 5% decline in the SPDR Trust (SPY) using put options. With all examples I’m using the February 21st expiration date.
Outright Put Purchase
The simplest and most straightforward way to establish downside protection is through the outright purchase of puts. With the SPY trading around $275, one can buy the $270 strike puts with an August expiration for $3.50 a contract.
The advantages: Benefit from an increase in implied volatility. It provides unlimited profit potential or downside protection. You can take close it for a large profit at any point prior to expiration.
The Disadvantages: It is negatively impacted by a time decay and decline in implied volatility.
Basic Vertical Spread
A vertical put spread involves simultaneously buying puts and selling an equal number with a lower strike price with the same expiration date. For example; August $275 puts and sell then $260 puts for a net debit of $2 for the spread.
The advantages: A spread greatly reduces the cost. Mitigates the impact of time decay and implied volatility.
The Disadvantages: Profits /protection is limited to the width of the spread. In the example above the maximum gain is $13 and would be realized if SPY is below $260 at the August expiration.
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Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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