Today’s Trading Lesson From TradingMarkets
Editor’s Note:
Each night we feature a different lesson from
TM University. I hope you enjoy and profit from these.
E-mail me if you have
any questions.
Brice
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Using Options To Protect Your Portfolio
face=”arial, helvetica” size=2>“The worst bear market since 1974-1975,†The
Wall Street Journal says of the Nasdaq this year.style=”mso-spacerun: yes”> I’m glad to hear that it’s that bad, because
this meltdown has really hurt. I don’t
know if I could have endured much worse.style=”mso-spacerun: yes”>Â And the statement contains, at least for me,
the implication that the carnage might be over soon.
face=”arial, helvetica” size=2>Even if the selling continues, the good news is
that hedging with options is a terrific way to fight back.style=”mso-spacerun: yes”>Â The simplest ways to hedge a stock portfolio
are buying puts or selling calls. I
prefer buying puts, because if the next selling wave carries the market deep, I
want my puts working harder for me the farther the selloff goes.style=”mso-spacerun: yes”>Â This happens automatically because as the puts
get driven into the money, their delta naturally increases.style=”mso-spacerun: yes”>Â In contrast, short calls would be going out of
the money at that time, their delta dropping, and their protection growing
weaker.
face=”arial, helvetica” size=2>You can either buy puts on each of your
individual stock holdings, or buy an appropriate number of index puts.style=”mso-spacerun: yes”> I prefer the latter because it’s so much
simpler to get in and out of my puts at various stages of the bear market.style=”mso-spacerun: yes”> Ideally, you should pick an index that is
indicative of your portfolio, and has a liquid options market.style=”mso-spacerun: yes”>Â For instance, the (href=”goto~www.tradingmarkets.com~redirect.cfm?symbol=QQQ”>QQQ) matches up
really well with my tech stock portfolio, and its options are heavily
traded.
face=”arial, helvetica” size=2>To figure an appropriate number of index options
to buy, you start with the dollar value of your stock portfolio, divide by the
price of the index, and apply a “fudge factor†for beta.style=”mso-spacerun: yes”> For example, I think my stocks are 30% more
volatile than the QQQ, so I multiply by 1.30.style=”mso-spacerun: yes”>Â (Note that a new facility is being built into
the OptionVue 5 software very soon for calculating this more exactly.style=”mso-spacerun: yes”>Â Meanwhile, this seat-of-your-pants approach is
not bad.)Â The result is the number of
equivalent deltas of the index your portfolio represents.
face=”arial, helvetica” size=2>For example, let’s say you have $150,000 worth of
high-tech stocks. Divide by the price of
the QQQ (currently 70) and multiply by a beta fudge factor of, say, 1.30, and
you have ~2,800 QQQ deltas. In other
words, it’s as though you have approximately 2,800 shares of the QQQ.
face=”arial, helvetica” size=2>To hedge this fully, you would need to buy enough
puts (and/or sell enough calls) to bring your net delta down to zero.style=”mso-spacerun: yes”> Using at-the-money puts — with a typical delta
of 50 each — this would require 56 puts (2,800 divided by 50).
face=”arial, helvetica” size=2>To partially hedge, you could buy fewer than 56
put contracts. To over-hedge (something I
like to do when I feel sure the market is going down), you could buy more
than 56 contracts.
face=”arial, helvetica” size=2>To illustrate how effectively options can be used
to cushion the pain of a bear market, I would like to relate my experiences of
the past three months.
face=”arial, helvetica” size=2>From Sept. 1 through mid-November, I allowed my
stock portfolio to go un-hedged, because I was not convinced that we were in a
bear market. (In retrospect, I can see
all the head-and-shoulder formations clearly now.style=”mso-spacerun: yes”>Â Duh!)Â
As a result, my portfolio was decimated.style=”mso-spacerun: yes”>Â However, in mid-November I decided to begin
fighting back. I sold off several losing
stocks to raise cash (and help offset gains from earlier this year) and I bought
puts as the market went into another swoon.style=”mso-spacerun: yes”>Â Several up-and-down swings later, and with
some lucky timing, my portfolio was back to its Sept.1 value.style=”mso-spacerun: yes”>Â
face=”arial, helvetica” size=2>I say this not to brag (goodness knows there are
many readers who have suffered greatly in this selloff), but to illustrate what
a powerful weapon options are. Rather
than just selling all my stocks and sitting out (and being nervous about missing
out on the start of the next big rally), I’ve been able to keep most of my
favorites and offset their declines with put gains.style=”mso-spacerun: yes”>Â Here I am now, with the market near a bottom
(hopefully), and tech stocks at bargain prices, and plenty of resources with
which to buy into the next bull phase of the tech revolution.
face=”arial, helvetica” size=2>Since options are so expensive these days, it is
important to buy and sell them in rhythm with the market.style=”mso-spacerun: yes”>Â
face=”arial, helvetica” size=2>I’m not sure how one obtains a feel for the
rhythm of the market, except through experience.style=”mso-spacerun: yes”>Â But I will say that the market is way more
predictable during a selloff. For
example, following a sharp break and a 50% rebound, it’s a pretty safe bet to go
short. You could stay short until the
market either returns to the previous low, or has a climactic selloff day.style=”mso-spacerun: yes”>Â If you can catch the Nasdaq in a climactic
selloff day (200 points or more in the current context), that’s a beautiful
opportunity to sell the puts and let your stocks go back up unhedged — maybe
even buy a few calls for a 24-hour play — as there most certainly will be a
smart rebound. When the rebound is
finished, you can think about shopping for puts again.style=”mso-spacerun: yes”>Â And so it goes.
face=”arial, helvetica” size=2>I would not just buy puts and let them sit.style=”mso-spacerun: yes”>Â This might work for some people, but I prefer
to time the market. I browse through a
lot of stock charts every day. If I see a
lot of stocks ready for another “break,†then I figure the market is about to
“break.†That’s when I buy puts.style=”mso-spacerun: yes”> I sell my puts in three to six days when it
looks like the current selloff has run its course.