The S&P and Nasdaq are down about 20% and 30%, respectively. The last two bear markets (even with Fed assisted interest rate lowering) clocked the S&P in 2000 for 50% and the 2007 S&P for 58%. The Nasdaq was blasted from 2000-2003 for a hefty 82%.
If you believe the market can go lower over the next couple of years, there is still time (hopefully after a rally) to hedge your portfolio for free. That’s right, free insurance if you put on a 1-for-1 collar spread. The call sale pays for the put purchase.
You can actually collect 3-4% if you do what Mr. Sears recommends below, which is buying a put spread in addition to the call sale. However, if the stock goes below the lower level of the put sale, you will be liable to buy the stock at that price if the put is exercised and you do not close out the short put.
This Options Strategy Can Protect Your Portfolio—and Position You for Gains
By Steven M. Sears- Updated September 23, 2022 / Original September 22, 202
Hope springs eternal on Wall Street—until making money gets tough. When that happens, investors lose their minds one by one and then all at once.
In those chaotic moments when everyone is afraid of losing, scared investors clamor to pay top dollar for put options, which increase in value when stock prices drop. Dealers who sell hedges to panicky investors emerge as the true winners.
The ideal time to hedge is when no one wants to buy bearish puts, but most people would rather stay high on “hopium” than consider something grim might happen.
When we suggested in early August that investors consider hedging their portfolio, the stock market was galloping higher and most everyone was confident the Federal Reserve would pivot to slow the pace of interest-rate hikes and pilot the economy to a so-called soft landing.
At the time, investors could have protected years of investment returns for little to no cost. Since then, investor sentiment has, to put it mildly, soured. Fed Chairman Jerome Powell has warned investors to prepare for painful conditions. It’s now considered a fait accompli that the Fed will continue to raise rates aggressively to battle inflation.
Since early August, the SPDR S&P 500 exchange-traded fund (ticker: SPY) has fallen some 11%, and the Cboe Volatility Index, or VIX, is up almost 43%. The challenge now becomes trying to hedge without paying so much money that it creates another huge payday for market dealers.
For well-heeled investors, we almost always favor selling puts on blue-chip stocks that can be warehoused for three to five years, which is enough time for most troubles to fade. Other investors want to hedge so they can feel they have protected themselves against deeper stock declines and a ruthless recession.
Most unsophisticated options investors hedge with S&P 500 index puts that have strike prices at, or just below, the index’s market price. Few investors realize they are buying puts that are so obscenely priced that the moon would have to catch fire for them to pay off.
A more thoughtful hedge is to establish bullish and bearish ranges with a “put-spread collar,” which are popular with sophisticated investors. The strategy allows you to limit gains to, say, 10% of your investments and losses to 20%.
Here’s how it works. When the SPDR S&P 500 ETF was at $414 in early August, we suggested selling the January $460 call option, buying the January $375 put, and selling the January $335 put. The put-spread collar paid investors $1.10 for limiting their gains to $460 and positioned them to profit if the ETF fell from $375 to $335.
Things have changed. That put-spread collar now costs about $13.36 to implement. In other words, the hedge—had you bought it back in August—is worth some 10 times more than it was then.
The investment puzzle that must now be solved is creating a reasonably priced hedge when the market mob is mad with fear and expenses are radically higher. Investors must choose between hedging Armageddon at reasonable prices and everything else at more expensive prices.
With the S&P 500 ETF at $367.95, investors can sell the January $405 call, buy the January $330 put, and sell the January $295 put. The put-spread collar generates a credit of about $2.25.
For the ETF to hit $295, the stock market would have collapsed below technical levels, analysts would have radically lowered earnings estimates, and the U.S. economy, and likely the world, would be groaning under the weight of a recession.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.
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