After This Market ‘Melt-Up’, Here’s How To Protect Your Portfolio Using Options

The stock market is hitting new all-time highs every other day and volatility is sinking to historically low levels.

Traders need to start thinking about hedging their overall stock holdings.

This can be done easily with the purchase of put options using a spread and with the lower VIX.

And it can be implemented cheaper than ever.

The Spyder Trust (SPY) will be the index to use to protect an overall portfolio in which individual stock positions tend to be bullish.

The factors to do this are based on how much of a percentage a trader wants to be hedged, how long a timeframe and from what price level.

Traders do not need many chart skills to see the record-breaking run this market has produced as the slope of the rise is taken on a vertical stance.

This extreme momentum can continue but the nature of this one-way movement screams for an overbought dip.

The breakout in the SPY ETF which tracks the S&P index at the start of this year from the 265-270 level has been relentless adding to last year’s overall gains.

The price level now has reached a record high above the 200 Day Moving Average percent wise that will over time have to adjust back to the mean reversion to work off the overbought conditions.

The stochastic indicator on the chart represents momentum against the high low-price range over a period of time holding above 80 which is considered overbought and a sell signal.

Looking at the chart a pullback to the 265-270 level is the first support.

A bigger drop towards the 100 Day Moving Average can take the index down to the 260 level.

This is after the massive rise we have had, and that rise defines the minimum percent to hedge against the stocks in your portfolio if you plan to hold them long term AND protect against any major short-term drawdowns.

Timing these type of moves is not the goal of the strategy only deciding the time period and the amount one wants to spend insuring against that move is what a trader can control.

The trade using options will be a bear put spread.

This is a vertical spread but instead of using calls, traders will use puts instead to profit from a decline in the underlying asset.

The same rules apply for puts like calls is to buy and sell the same number of contracts of different strike prices to capture the difference in price between the spread.

This is cheaper than just buying an outright put to protect downside as the sale of the lower strike price will lower the cost of buying the higher strike.

The other advantage is the risk is defined to the initial cost outlay and does not need to be monitored.

This will protect a downside move as the put of the higher strike will increase if the SPY goes down towards the lower priced strike. The profit will be the price difference between the strike prices minus the debit paid to buy the spread. The bigger the spread the more it will cost but that, in turn, will raise the profit potential.

The SPY is now trading the 282 level a dip back to the 100 DMA at the 250 level will be close to a 7-10% correction which can be hedged using the spread of the 275 strike over the 255 strike objective.

To fully protect a $50,000 portfolio from a 10% decline within the next 6 months I would:

>Buy the 3 contracts June 275 put and sell the 3 contracts June $255 put for a net debit of $3.00 or $900 for the 3 contract spread.

Here is what the order ticket looks like:

The cost of $900 is just 1.8% of the $50,000 which is very inexpensive to purchase 6 months or portfolio insurance.

Here is the risk/reward profile:

As you can see should the SPY decline by 10% towards the 250 price level that would place the spread fully in-the-money and realize a maximum profit.

On $5,100 which would more than offset the $5,000 drawdown that would be incurred by $50,000 portfolio.

For less than 2% of your portfolio’s value, you can rest assured you’re protected for the next 6 months by using options as an addition to your portfolio.

— The Option Specialist

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About the Author: The Option Specialist