Tales of a Technician: A Trick for Financing Portfolio Protection | Tackle Trading

In Tagging the Golden Goose: A Lesson in Portfolio Protection we investigated the choices facing stock investors in search of protection. The whiz bang idea for paying for the insurance policy (LEAPS puts) was to sell OTM call options every month or two. Those unexcited about the idea, but still open to additional strategies for curbing the onerous cost of buying LEAPS puts will be happy to know I have another tactic worth consideration.

Let’s recap the situation:

First: you have $100K invested in the S&P 500 via SPY. With SPY perched at $193.50 you own around 500 shares.

Second: To acquire protection you purchased five Jan 2017 175 strike put options for $1,000 apiece. The puts sit 10% OTM and provide protection for one year. All told you’re paying $5,000 or about 5% of your portfolio for the protection. As mentioned in the newsletter I’m not a fan of paying 5% of your portfolio to acquire puts every year. The cost is too burdensome.

Instead of selling covered calls to partially finance the put purchase, what else could we do? How about selling further OTM Jan 2017 puts? In other words, buy a put spread instead of straight puts. For example, what if we bought the Jan 2017 175 put for $10.00 while selling the Jan 145 put for $4.00.

The $4.00 received from the short put reduces the protection cost from $1,000 to $600 per contract. That’s a 40% reduction. The catch is that your protection now has a limit. The long 175 put locks in the right to sell your SPY shares at $175 affording protection down until the short put at $145. Essentially once SPY falls below $145 your insurance policy runs out and you’re back to full exposure. Here’s another way to think about it. The $175 put is 10% OTM so once the SPY drops 10% or more your protection kicks-in. The short 145 puts sits 25% OTM so if the market somehow drops more than 25% the protection disappears.

Risk graphs come in handy to illustrate the difference. First, checkout the long SPY position with the LEAPS put for protection. At expiration the put kicks-in at $175 to minimize any further loss. The downside is you now have to make $10 per share on the stock just to pay for the insurance.

The next risk graph shows the long SPY position with a Jan 175/145 put spread purchased for $6.00

Just like the prior position the long put kicks-in at $175 to eliminate any further loss from that point forward. Unlike the prior position, however, the protection only lasts until $145. At that point the short 145 put offsets the long put and you’re back to your straight long SPY position. What’s the upside for cutting off the protection like that? We received $4.00 from the short 145 put which cut the cost of our yearly insurance policy from $10 to $6 per share.

If you want the protection to go further, then don’t sell the 145 put. Maybe sell the Jan 135 strike instead. That won’t cut off the protection provided by the put spread until SPY has fallen 30%. Bear in mind this option includes a tradeoff. The 135 put is only worth $2.80, so it only reduces the portfolio protection to $7.20 from $10.00 instead of reducing it to $6.00. In the end you have to decide which lower strike put provides the optimal trade-off between cost and protection.

Given how uncommon it is for the SPY to fall 25% to 30% I certainly wouldn’t mind losing protection at that point in exchange for a 30% to 40% reduction to the annual cost of the insurance.

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Originally published at https://tackletrading.com on March 2, 2016.