Correction Protection

With the market near all-time highs and implied volatility back near lows using options to protect your portfolio from a correction makes sense.  Here are two low cost strategies. 

Since hitting the $204 low last week the SPDR 500 Trust (SPY) has rallied some 3.1%, including it’s best 3 day performance of the year.  It is now hitting important resistance at the 20 and 50 day moving averages at the $210-$211 level.

While the long term up trend remains in place it should be noted the recent rebound has come on decreasing volume.  This lack of commitment suggests it may be difficult to take out the all time highs which had a failed breakout creating a double top in mid-June.

SPY chart annotated 7.14.15

Prudent Protection

I’m not predicting a bear market but with valuations becoming stretched, interest rates poised to rise and renewed strength in the dollar likely to pinch second quarter earnings reports, to say nothing of the ongoing macro issues in China and Euroland, there are plenty of catalysts that could trigger a standard 10% correction.

The quick recovery in stocks has sent implied volatility low as measured by the plummeting; the VIX has slumped some 35% in the past four session to the 13 level.  With stock prices high and option premium low it seems prudent to buy some portfolio protection.

Two Ways to Spread Cost

Given that I’m not outright bearish and mainly want to protect in case there is a correction in the 10% range I want to keep the cost of my portfolio insurance as low as possible.  That means using a spread strategy.

Spreads come in many flavors and formats but the main concept is to use the sale of one strike to help finance or reduce the cost of the simultaneous purchase of another strike.  The trade-off of the lower cost or reduced risk is that profits will be capped and/or  difficult to capture prior to the expiration date.

Let’s look at two spread strategies in the SPY that could be used to protect against 10% decline to around $180 level over the next one –two months.

The first is the basic vertical put spread.  This consists of buying a near the money option and selling an equal number of out-of-the money options with the same expiration date.  For this strategy I want to use the September expiration date.

Specifically;

-Buy September $205 puts

-Sell September 185 puts

For a $2.20 net debit 

Here is the risk/reward and pertinent stats on this strategy.

SPy sep spread rris graph 7.14.15

Note the attractive risk reward of 8:1.  And if SPY declines quickly full profits can be realized any time prior to expiration.

Butterfly Spread

Now let’s get a little more creative and use a butterfly spread.  A butterfly spread uses three strikes.  The standard is a 1x2x1 construction with the strikes equi-distant from each other.  I want to put a little twist and use a 1x3x2 construction; this is often referred to as a ‘broken wing’ or ‘skip strip’ butterfly.   A skip strike butterfly helps expand the profit zone while reducing the cost.

Because of the offsetting purchase, sale, purchase construction the value of butterfly spreads remains very stable even as price of the underlying or volatility levels change until you get close to expiration.   This brings up the main drawback of butterfly spreads; it is very difficult to take profits prior to expiration.  Butterfly spreads are positions you put on, forget about and check back to see if it’s your profit zone a few days before expiration.

For this reason I want to focus the August expiration.  It will give us a low cost way to protect in against the SPY is 3%-7% lower four weeks from now.

The specific butterfly I’m targeting is:

-Buy 1 August $205 puts

-Sell 3 August 195 puts 

 Buy 2 August 190 puts

For a $0.60 net debit. 

SPY August butterfly risk 7.14.15

The butterfly spread offers an even more attractive risk/reward o 15:1.  But note, maximum profits can only be realized if SPY shares are at the $195 strike at expiration.  Meaning, you need to right about both price and time to fully benefit.   But thanks to its low cost and relatively wide profit zone it’s good way to get low cost protection for a defined period.

— Steve Smith

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About the Author: Steve Smith