Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Portfolio protection
I have a longer-term portfolio of stocks that I’d like to protect against any repeat performances of 2008 into March 2009. How can this be done with options?
That’s a good question, but the answer doesn’t lend itself to one size fits all. Depending on how many stocks are in your portfolio, call and put liquidity within those individual issues, your risk and reward preferences, and how much time you’re willing to allocate to managing positions will lead to very different courses of action in the option market.
An investor with long-term holdings in a handful of stocks with liquidly traded options might consider actively managing each situation separately from his or her other holdings. The time required to maintain a portfolio hedged with options shouldn’t be prohibitive, even if that person works full time and can’t commit to monitoring the market throughout the day.
In this situation, many investors look at establishing either buy-writes or collars on their stocks. The former, the most popular strategy with investors, takes in premium by selling a call one-to-one against the amount of shares held in the underlying and has the effect of reducing the cost basis of the position.
The buy-write can be likened to collecting a dividend; receive enough of these “dividends” via multiple call sales and the trader could have ownership of the stock for free. However, there is assignment risk that needs to be managed, unlike with a cash distribution from the company.
In addition, despite being the most popular strategy and one typically discussed as a conservative means to investing, the buy-write only offers limited protection up to the amount of the premium sold. During an abrupt corrective move, a premium collection strategy such as the buy-write will undoubtedly feel like inadequate protection.
The collar strategy goes one step further by incorporating downside protection with a long put purchase. The put is initiated on a lower strike than the call sale and most often of the same expiration, but not always. With the collar, the trader can steer clear of the sometimes hard and unmanaged loss associated with the buy-write.
Another idea for protecting an overall portfolio is to use a bearish risk reversal on a correlated index. This is simply the option portion of the collar without executing the long stock (index) component as the trader is already long his or her individual holdings.
This strategy is strengthened by first finding the portfolio’s dollar-based risk profile based on the components combined beta values — that is, correlation or systematic risk. For investors facing less liquid individual stock option markets and/or less time to portfolio management, this might be considered an alternative hedge.
To illustrate, say you have $50,000 in individual positions and each security has a beta of 2.00. That means for each percent gain in the broader market we might expect our individual stocks to move up 2% and inversely lose twice as much on the downside. In order to more effectively hedge our real exposure to market swings, we would multiply our dollar risk of $50,000 by the portfolio’s beta of 2.00 to derive a figure of $100,000, which we need to hedge against.
Using the S&P 500 exchange traded fund (Spy) priced near $110, one contract represents 100 shares of the underlying or $11,000 in market exposure once exercised or assigned into the underlying. Thus, for our hypothetical portfolio with $100,000 worth of risk, the trader would be looking at the purchase of nine put contracts and sale of nine calls for a simple yet effective hedge, as $99,000 (nine contracts x $11,000) is a near-perfect fit relative to the portfolio’s adjusted-dollar risk derived from beta.
One caveat with this method: company-specific risk does remain, as broader market protection won’t compensate for potential catastrophes that might occur in an individual stock. In addition, since beta is fluid, a change in that value in one or more securities can mean our “near-perfect” fit is less correlated than initially determined. Ultimately, and in both these situations, if the trader hedged each component individually, these potentially hidden risks would be eliminated.
Too good to be true?
A while ago, I came across some options in Stanley Black & Decker (Swk) that looked too good to be true. The March 60 call was priced such that by purchasing the 55/60 bull call spread, the trader would receive a substantial credit and seemingly couldn’t lose on the position. What gives?
Congrats on looking at the situation with a skeptical eye. Finding a realistic theoretical edge with options is one thing, but heeding the adage “There’s no free lunch on Wall Street” is always worth remembering and most certainly applicable with some Stanley Works options.
What you were looking at was a nonstandard contract situation related to its merger with Black & Decker. The 60 strike call you were seeing maintained delivery terms different from one contract = 100 shares of underlying, associated with a normal call or put listing.
Typically, these options aren’t listed alongside a regular contract to avoid such confusion and an unwanted position. My guess is you may have clicked on a request for such information within your trading platform without realizing it, which then grouped both types of standard and nonstandard contracts together.
I don’t know the exact terms of this contract, but that type of information can be found by going to www.optionsclearing.com, the website for the Options Clearing Corp. Even without knowing the specifics of the nonstandard contract, I can say that positioning in such an instrument against a regular contract, like the described vertical, wouldn’t net a trader a lock on profitability and could wind up being a costly and unwanted headache.
Contributing analysis by senior Optionetics strategist Chris Tyler.