Take Chips Off the table? Using the Portfolio Put Strategy

Is the market’s recent Central Bank inspired rally causing you to think I better get out before it reverses and I give any gains all back? Last week I wrote about using overwritten covered calls to reduce the exposure of a specific stock holding. Today I discuss the 2nd potential strategy, the portfolio put. This strategy is designed for investors looking to take some chips off the table, given the recent rally which accelerated last week.  A portfolio put can hedge an entire portfolio with one broad based ETF put option purchase.

For a complete description of the portfolio put take the time to view our Webinar Series from Buy and Hedge. http://optionshouse.com/webinars/trading-strategies-from-the-authors-of-buy-and-hedge-part-2/ This strategy is discussed in Part 2.

For most U.S. equity portfolios the S&P 500 index is the benchmark. The ETF on this index is the SPDR S&P 500 (SPY) which is extremely liquid. To construct the proper hedge investors need to determine how many option contracts, which month to purchase those contracts and which strike price to choose? Using the OptionsHouse Risk Viewer tool and applying some simple math will enable you to determine how many puts will hedge your current market exposure. The Risk Viewer can quickly show you your Beta weighted exposure in dollar deltas on the Greeks Tab. In my virtual example below this portfolio has a dollar delta of 204,000 dollars.


The SPY ETF is currently trading at 147.  So to determine how many contracts would hedge this portfolio simply take the 204,000 divided by 147 to get the number of SPY shares which this is long equivalent = 1388 shares.  Divide by 100 as each option contract controls 100 shares of stock 13.88 contracts.  Let’s round that to 14 contracts.


Next you need to determine the correct month to purchase your portfolio put hedge.  Fundamentally, you may wish to hedge the rest of the calendar year since the market has risen 17% on the year.  Or perhaps you want to remove some uncertainty through the November elections.  Theoretically, it is important to mold your fundamental view with the knowledge that options are a wasting asset.  They decay over time with the highest percentage of the decay taking place in the last days and weeks of an options life.  So while a shorter term option will cost less premium at the onset, a longer term option will experience less premium decay each and every day.  This is measured by the Theta of the option and can be found on the Option Chain using the Greeks Format.   I would suggest going out a bit further from your fundamental forecast for 2 reasons.  You will reduce the amount of decay today and remember, you can always sell the long put out before expiration should you no longer require it.

The final step in constructing the correct Portfolio Put trade is determining the strike price.  Again as we did with the covered call example we are going to use delta as our guide.  How much portfolio risk do we want to hedge?  An at-the-money (ATM) put will have about a 50 delta.  This means that this put option should theoretically move 50% of the overall market’s move.  Another way to think about it is the premium required to pay is your hedge premium to limit any downside from this ATM point.  This put would be more expensive than an out of the money downside put.  Again look at the delta.  Let’s use for an example you have the desire to take about a third of your chips (market exposure) off the table through the end of year.  In SPY they actually trade Quarterly options which allow this specific hedge trade and these quarterlys expire on December 31st.  The 140 strike puts with this end of year expiration date, exhibit a 31 delta today and since this is an approximate hedge that is close enough for our purpose.  The premium required today is $2.88 on these 140 puts, which should be analyzed as a percent of the current stock price, (2.88/147.00) = 1.95%.  Further since the strike price is positioned 7 points below the current spot, 7 points divided by 147 is 4.76% to the downside. 

These calcualations are important because should the market fall you know that you have a put hedge, which at expiration will allow you the right to sell the SPY ETF stock 4.75% below the current level.  Add the premium required for this put, and you might possibly sleep better at night knowing that should the market fall, you will theoretically make money on your SPY puts and mitigate losses beyond down 6.70% from the current levels.    Remember puts on the SPY move inversely to market moves between now and expiry, today close to the put’s delta of 31%.    This delta will change due to the passage of time and the price of the underlying.  So continue to monitor your Risk Viewer to get a complete picture of your portfolio’s exposure.

After purchasing a portfolio put you still are long the market, and you still definitely want the market to continue to appreciate, however the downside is mitigated on an overall market move lower.  You can view your slide risk looking one more time at the Risk Viewer:

Again, this is not a buy, sell, or hold recommendation, but simply an example of how stock investors can use a Portfolio Put option to take some chips off the table on an entire portfolio of appreciated stock positions.   Next time I will discuss using in the money call options to provide stock investors hedged long exposure to this market. 

Steve Claussen http://www.optionshouse.com