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Thoughts about put options as hedge to market corrections
Old 09-17-2013, 03:44 PM   #1
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Thoughts about put options as hedge to market corrections

hello,

was wondering if anyone out there has any advice/thoughts regarding the use of "put options" as a means of providing insurance as a hedge to cover against potential large market corrections - or to minimize losses
(if and when there actually is a correction).

some of the approaches I've read on the topic suggest spending 1% of your total stock portfolio. In my case, stock related funds/individual stocks amounts to about $500k. I do have about $183k in bond funds and another $143k in money markets.

Since I want to stay consistent with my current portfolio mix, I don't want to sell off any stocks or funds. Was researching put options against the SPY (to keep things simple).

Obviously, I will try to ride out the usual ups and downs, but I'm concerned primarily about a bigger correction, say 10-20% that could potentially occur over the next year to year and a half.

Any thoughts on good strategies relative to put options (specifically SPY).

What's a good option length to buy (example 1 year contracts are more expensive, or do you buy shorter term contracts and just re-buy at 6 month intervals)

Thanks.
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Old 09-17-2013, 04:09 PM   #2
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I've never bought a put since they can expire worthless. I have sold them, and if the stock is put to me, I get it at a cheaper price.
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Old 09-17-2013, 05:24 PM   #3
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I looked into buying at the money and slighly out of the money puts a number of years ago for the same reason. At the time, the cost was pretty steep and I passed. I'll be interested to see the responses and I have some interest at the right price.
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Old 09-17-2013, 05:26 PM   #4
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I do not use these, sorry.
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Old 09-17-2013, 06:48 PM   #5
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They are fun to use on some individual stocks that get run up on tulip craze, but I don't know about using them to protect your portfolio.

I want so bad to buy them on Tesla but they are too expensive at the moment. I think Tesla still has a few years before people realize they are never going to turn a profit so puts could be money losing right now.
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Old 09-17-2013, 08:33 PM   #6
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It's insurance so it's going to have a negative expected return. The only way you can come out ahead is if you get lucky or the seller has seriously mis-priced them (not likely).

I would only buy such an option if I was extremely exposed and wanted to cut my risk (e.g., I had a windfall in terms of stock options vesting and I wanted to protect against a downfall before I could sell them).
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Old 09-17-2013, 08:42 PM   #7
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Puts are expensive and therefore I have not bothered. However, historical price data does exist. I wonder if anyone has done any research on whether using index puts for say, the first 5 years of your withdrawals, might mitigate the sequence of returns problem.
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Old 09-18-2013, 01:49 AM   #8
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I've used put options as a hedge in the past, but as with all options, they must be used extremely judiciously. I've learned that there's not a "one size fits all" strategy. Unless I had some proprietary information on a specific company, (let's not kid ourselves, people,it happens) I would usually only buy protective puts on an index, such as the S&P 500 (SPY).
When I've done puts as a hedge, I've usually done a put spread; long the higher strike, and short the lower strike. And I usually don't go out more than 30-60 days until expiration.
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Old 09-18-2013, 08:27 PM   #9
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Quote:
Originally Posted by Russman View Post
...

Obviously, I will try to ride out the usual ups and downs, but I'm concerned primarily about a bigger correction, say 10-20% that could potentially occur over the next year to year and a half.

Any thoughts on good strategies relative to put options (specifically SPY).

What's a good option length to buy (example 1 year contracts are more expensive, or do you buy shorter term contracts and just re-buy at 6 month intervals)

Thanks.
Like the others, I'm skeptical that buying puts on SPY can accomplish anything in the long run. I can see buying puts for the short term to cover a specific upcoming event (like an earnings report) on an individual stock that you might want to hold long term, if that news event is positive.

I just looked up puts on SPY, closed at 173 today. You can buy a 135 put, one year out (protected at 22% below 173) for $2.60 (~ 1.5% of 173). Now that doesn't sound too bad, but what happens if SPY is ~140 a year from now? That was above your protection point, and now it will cost much more to protect @ 135 for the next year. And you would have lost the time decay in that 135 put, so it probably won't be worth much.

So it's easy to picture a big drop early on where the put protects you, but that probably won't happen, and then you just have to keep maintaining that cover. It can get expensive.

-ERD50
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Old 09-19-2013, 05:26 AM   #10
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Like the others, I'm skeptical that buying puts on SPY can accomplish anything in the long run. I can see buying puts for the short term to cover a specific upcoming event (like an earnings report) on an individual stock that you might want to hold long term, if that news event is positive.

I just looked up puts on SPY, closed at 173 today. You can buy a 135 put, one year out (protected at 22% below 173) for $2.60 (~ 1.5% of 173). Now that doesn't sound too bad, but what happens if SPY is ~140 a year from now? That was above your protection point, and now it will cost much more to protect @ 135 for the next year. And you would have lost the time decay in that 135 put, so it probably won't be worth much.

So it's easy to picture a big drop early on where the put protects you, but that probably won't happen, and then you just have to keep maintaining that cover. It can get expensive.

-ERD50
I really want to be able to use puts to protect my portfolio but sadly the insurance cost just seems to high. With the market at record highs, the volatility index (VIX 13.59) near record lows, and interest rates very low this is the ideal time to purchase puts. But as ERD point this still is pretty expensive if you had 3000 SPY shares worth ~$521K buying a year long put would cost $7800 . You'd have to have to lose more than 120K before you'd collect a dime in insurance money.

Compared to say home insurance or even hurricane,flood, or earthquake insurance this is still a very high premium and crazy high deductible.

Interestingly it is relatively cheap to insure against a greater than 20% drop in the value of your home. A 30 year mortgage with 20% down or less does the trick pretty easily.
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Old 09-19-2013, 07:02 AM   #11
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Something you might consider is to purchase a put spread and sell a slightly out-of-the-money call to finance it.

For example, near the close yesterday, with SPY at 173, you could buy the 168/158 Dec21 put spread and sell the Dec21 177 call for a credit of about 0.07 before commissions. If you're willing to give up further gains above 2.3% and self-insure the first 3% of the drop, this will give you pretty nice insurance against a substantial drop (about 9%) over the next 3 months at basically no cost.

You can play around with the strikes and expirations to structure the trade to fit your market outlook.
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Old 09-19-2013, 09:37 AM   #12
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Using puts as insurance might be useful only if you need to liquidate equities at a certain time for some reason. In other words, you need X amount for living expenses. Or to buy a car. If you don't have a plan to sell equities at a certain time, put options would not be worthwhile. In other words, just ride the storm out.

You might actually think about selling puts if you thought you might want to increase your equity exposure if the market goes down. If it does, you get put at the lower level. If it doesn't, you get to keep the option premium.
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Old 09-19-2013, 10:32 AM   #13
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You might actually think about selling puts if you thought you might want to increase your equity exposure if the market goes down. If it does, you get put at the lower level. If it doesn't, you get to keep the option premium.
From time to time I sell puts when I want to incrementally increase my exposure to a certain issuer (not index/etf). This really only works when the put prices are juicy, which may imply significant risk. Most of the time, this has worked out well for me, though. I already like and usually own the name. I understand what I am getting into. I have a long planned hold time, and the puts are juicy enough that if I just end up keeping the premium I won't much be troubled. But you have to understand what you are playing with and you really need to be good about not having buyer's remorse.
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Old 09-19-2013, 10:33 AM   #14
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I looked into buying at the money and slighly out of the money puts a number of years ago for the same reason. At the time, the cost was pretty steep and I passed. I'll be interested to see the responses and I have some interest at the right price.
That's about the conclusion I came to. A LEAP Put for a Dec 2014 at $170 ($3) down from today is just under $13. Basically, you end up pricing in a guaranteed 10% hit with the leap. Further out at a $160 strike, they're still $9+

So on the $160, the closer you get to the expiration date, the more the stock would need to fall, in this case all the way to $151 before you even break even.
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Old 09-19-2013, 10:59 AM   #15
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I've used put options as a hedge in the past, but as with all options, they must be used extremely judiciously. I've learned that there's not a "one size fits all" strategy. Unless I had some proprietary information on a specific company, (let's not kid ourselves, people,it happens).
Clever of you to announce this on the internet.

Ha
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Old 09-19-2013, 12:58 PM   #16
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Something you might consider is to purchase a put spread and sell a slightly out-of-the-money call to finance it.

For example, near the close yesterday, with SPY at 173, you could buy the 168/158 Dec21 put spread and sell the Dec21 177 call for a credit of about 0.07 before commissions. If you're willing to give up further gains above 2.3% and self-insure the first 3% of the drop, this will give you pretty nice insurance against a substantial drop (about 9%) over the next 3 months at basically no cost.

You can play around with the strikes and expirations to structure the trade to fit your market outlook.
I'm am thinking of put spread wrong? I still see unlimited downside, just a mitigation of a mid-size correction?

You sell the deep loss PUT (i.e sell a $158 PUT)
you buy the small loss PUT (i.e buy a $168 PUT, basically a 3% loss)
you sell a near money CALL (i.e. sell a $177 CALL, 2.3% gain)
but you also need to be holding the underlying shares.

As long as it's not volatile, you'll be between -2.8% (loss) and 2.3% gain. If the stock goes below $158, your losses accelerate although you mitigate them by about 6%. If we get an sudden shock and a 20% correction, you end up down around 13% ( granted that's a lot better than down 20%). i.e. if SPY tanks to $140, both puts are executable and you net a $1000 from them, and you're still holding the underlying stock now worth $14,000. Unless you gutsily sold it and rode the naked call.

Although if there's still time left, I suppose you could buy the CALL back (it's not worth much)

Maybe it's just my outlook, but I tend to think downside in the market is either slow and small or big and sudden. Meaning it's either +/- a few percent with sudden big swings either over a day or couple days.
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Old 09-19-2013, 02:23 PM   #17
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For some of the big declines that came out of nowhere (1937 and 1987 come to mind) how would one have even anticipated setting up the put option?

Also, what about taxes? Never touched options but they seem to be tax inefficient. I know you are trying to partially avoid a large loss but isn't paying short term cap gains on the (if successful) put a bit of a turnoff?
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