Conversation with a Nervous Long

From a recent conversation with a reader: “With the market so high, I’m starting to think about buying puts. How do I decide:  Is there a best price to pay? Or a best delta or expiration date? How much of my account value dare I spend? When expiration nears, should I roll?”

It is one thing to anticipate a market top and protect your holdings. It is quite another to bet real money on a market decline.

Let’s tackle this logically. First, why do you want puts? Is your goal to avoid any loss? Do you want to avoid a catastrophe? Or do you expect a market debacle and want to make some big money?

Puts for protection: When protecting assets, buy an insurance policy. Puts are costly, so buy only enough puts to insure the value of your portfolio.

  • One Jun SPX 1500 put covers a diversified big-cap portfolio valued at $150,000
  • One May IWM 90 put covers a small-cap portfolio valued at  $9,000

Choose a strike that provides protection where it is needed. If (for example) you are willing to live with losing 10% of your portfolio value, then buy puts that are 10% out of the money. The best protection to buy puts on each of your stocks. If you own a diversified portfolio, consider buying puts on an index (SPX or RUT) or an ETF (SPY, IWM, DIA) that resembles your portfolio.

An alternative is to lighten up on your holdings. That is one way to protect a portion of your assets with no cash-out-of-pocket cost.
Puts for speculation: I am not a fan of speculating by buying OTM options. However, if you want to make that wager:

a) Betting on the large, rapid decline and corresponding IV increase?  You can afford to go far OTM and buy less-costly options because those will be winners if IV does surge.  Just remember that this is a long-shot.  Buying FOTM options is seldom a winning play.

Longer-dated expiration dates provides a chance to win even bigger if IV does explode. However, the initial trade costs more and involves placing more cash at risk.  Save your money by buying 3-4 week options.

b) Playing for a slower, steady decline?  You cannot afford to own short-term options because they are likely to expire worthless. This steady market decline may not bring far OTM options to life. If IV increases modestly.  Do not go far OTM when choosing strikes. Find a decent compromise, considering three factors: premium per option, quantity of options you can afford to buy, and choosing strikes that will attract buyers should your expectations come true.

c) Rolling is NOT part of the plan. The time to think about rolling out the puts occurs as expiration nears. That requires a separate decision for the future.

Here is my bottom line: Own insurance if you are concerned. Buy puts if you want to gamble. But do not overdo it. The market decline may not come for another 10 years. You must be aware of risk when chasing the dream of earning life-changing money.