Low Fear Levels Make For Cheap Option Protection
Bob Lang | Jun 08, 2015 03:41AM ET
Summer trading usually ushers in a time a low volatility and often very little interest. Markets tend to make sharp and jagged moves as liquidity is thin. At this time with markets at/near all time highs and nobody truly wants to get off the train, it makes for some difficulty but often some opportunities arise when others are looking the other way. Paraphrasing Robert Frost, 'The road less traveled makes all the difference'.
We often see some sort of 'summer rally' occur with alacrity, but with very little fear in markets today (VIX is under 15% and has been well under 20% since early February). This tells us option prices are cheap as the market expectation is not for big, sharp moves. Recently, the VIX came down to 12%, an area previously seen as a reversal (see chart). However, that tends to be a good contrary indicator. Hence, buying some puts as protection against your portfolio makes for one of the better options trading strategies.
So, if we do have a market rally during the summer months, then hooray for our long plays. But, what if that doesn't come to pass? What happens is some unforeseen event hits the market hard, or even if recent Greece news or Fed rate hikes start to get everyone uptight? There is quite a bit of downside action to be had if the market leans in that direction. Can you be protected?
Rising fear levels tend to increase the premium for options, especially put options. Puts increase in value as a stock or index declines, often dampening the volatility of a long-only portfolio (long call options or just stock). The beauty with put options is leverage, very little up front cash is needed to protect your stock positions. I nearly always have some put protection on just in case something in the market goes awry of expectations.
For me, one of the most ideal options trading strategies is just buying straight puts on one or two indices. These are some of the most liquid names (easier to get in/out) and they closely track the underlying. My first preferences are the index ETFs (exchange-traded funds) SPDR S&P 500 (ARCA:SPY), iShares Russell 2000 (ARCA:IWM), SPDR Dow Jones Industrial Average (ARCA:DIA) or PowerShares QQQ Trust Series 1 (NASDAQ:QQQ). I will choose the ETF which seems to be weakest or provides the best protection against my holdings with strong correlation.
We can complicate this with different structures that reduce risk, but with volatility so low option prices are not expensive. Ideally, to protect a portfolio of stocks I will buy puts that are 1-2% of the value of my overall portfolio. Hence, with a 100K account I may have 50K in option or stock plays outstanding and 50K in cash. To protect the 'invested' side I may buy 800-1200 dollars worth of puts, generally weekly options if they are offered and just keep rolling them.
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If the market rises I will lose money on these plays but if done right my long portion should overcome the losses. My overall volatility is dampened and my profit/loss is lower but I will give that up for some portfolio insurance.
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