Thursday, April 18, 2013

Guest Columnist at The Striking Price for Barron’s: How to Insure Your Stock Portfolio

Today’s guest column at The Striking Price on behalf of Steven Sears at Barron’s marks the tenth time I have had the opportunity to write a column for Barron’s and this time around I even managed to suppress the impulse to write about the VIX and volatility – at least directly.

In How to Insure Your Stock Portfolio I drill down on an element of hedging I cited in one of my hall of fame posts, Cheating with Partial Hedges. Specifically, I talk about bear put spreads, which I like to think of as “gap hedges” due to the fact that they offer protection should the underlying fall in between two strikes.

The Barron’s article talks about a specific SPY gap hedge strategy involving buying puts that are 5% out-of-the-money and offsetting some of the cost of the put protection (and capping the downside effectiveness) by selling puts that are 10% out-of-the-money. Done at a 1x1 ratio, this is a classic bear put spread that has the following effect on an SPY position:

[Graphic showing range of protection offered by 5% - 10% bear put spread or “gap hedge”]

What I didn’t have the space to discuss in the Barron’s article is the possibility of converting the 1x1 position into a ratio put spread by selling two 10% OTM puts for every one 5% OTM put that is purchased. With SPY closing at 154.14 today, the strike closest to a 5% pullback is 146, where the July puts currently at 2.55. At the same time, the 10% OTM strike is 139 and the July 139 puts are 1.40. With these numbers, a 1x2 ratio spread can be initiated for a credit of 0.25 (2x1.40 – 2.55) and provide protection down to SPY 139 (9.8% below today’s close) essentially for free. The big caveat here is that there is no such thing a free portfolio protection. What happens here is that in moving from a 1x1 put spread to a 1x2 ratio spread, the position is transformed from a limited risk position to a unlimited risk position where investors are exposed to the possibility of large losses should SPY fall below 139 prior to the July 20th expiration. For this reason, put ratio spreads – or any options trade with unlimited risk – should be utilized only by advanced options traders. In contrast, the standard 1x1 put spread is an excellent trade for beginning and intermediate options traders to seek to master.

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Four Years of SPX Pullbacks in One Plot

Each time stocks correct, I invariably receive requests from readers to update my SPX pullback summary data, as I did most recently on February 26th in Updated SPX Pullback Summary Table for SPX 1485, after the S&P 500 Index had pulled back 3.0% from a recent high.

Rather than simply add another row to that table to capture the peak-to-trough decline of 3.5% from Thursday’s high of SPX 1597 and today’s early session low of 1541, I thought it might be more instructive to update an old plot of all twenty pullbacks that I have catalogued since the March 2009 bottom in stocks.

In the plot below, the y-axis captures the magnitude of the peak-to-trough decline (inverted) and the x-axis records the duration of that move. At the risk of making the graphic somewhat of an eye chart, I have also included the peak VIX during the pullback as a red label for each dot. Just for fun, the long dotted black line is a linear fit of all the data points.

I have annotated the data for some of the larger pullbacks and have also highlighted the current pullback in blue text. Some might find it interesting to note that with the VIX has exceeded 19.00 in every pullback with the exception of the 17.90 peak VIX value during the current pullback.

Of course there is no guarantee that the current pullback will stop at 3.5%, but if it does, it will certainly be one of the mildest pullbacks of the 2009-2013 bull market.

[source(s): CBOE, Yahoo, VIX and More]

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