Considering Our Options – SPY: Portfolio Protection

by CC August 28, 2013 2:12 pm • Commentary

A few weeks ago we highlighted two potential portfolio protection trades on what appeared to be a possible inflection point in the market. Dan discussed one of the trades on CNBC’s Options Action on Aug 9th, exactly one week after the SPX made a new all time high:

Here are the two trades we highlighted on the site with Dan’s Options Action trade listed first:

Hedge 1 – Protection back to the June lows:
SPY ($169) Sell Dec31 175 Call vs Buying  Dec 31 165/154 Put Spread for even money
  • Sell 5 Dec31 175 call at 2.50
  • Buy 5 Dec31 165 Put for 5.00
  • Sell 5 Dec31 154 Put for 2.50


Hedge 2 – Crash Protection Below the January Low
SPY ($169) Sell Dec31 175 Call and Buying  Dec 31 155 Put for even money
  • Sell 5 Dec31 175 calls at 2.50
  • Buy 5 Dec31 155 puts for 2.50

Since that day we’ve seen the market come under selling pressure for a number of reasons. Today it’s found some footing and is up on the day which gives us a good opportunity to look at these trades from a management perspective.

First, let’s look at where they stand with the SPY at 164.40 or about 4.60 lower from the initiation point.

Trade 1 – Worth about $2.60 (paid even)

Trade 2 – Worth about $2.10 (paid even)

So both of these structures have taken some of the bite out of the selloff hedging more or less half of the down move in the market. What’s really interesting to me is just how well the crash trade (Trade 2) has performed in relation to the more conservative “correction” trade (Trade 1). A simple way to look at this is that Trade 1 is the more conservative of the two trades, and has a much more realistic chance of approaching the end of the year in-the-money, but since we have more than 4 months until these structures expire, it’s going to do well in a down moves just like the more realistic one. This is due to the fact that the two structures share the same short strike (175) but unlike the Trade 1, Trade 2 didn’t have a second short strike in the form of puts. What that means is both perform well under the current circumstances. And even though the crash trade doesn’t become ITM for quite a distance (155 vs 165) it has enough deltas this far out that it does pretty well. In fact, both trades have similar deltas at the moment (just under 50) but Trade 1’s deltas are more intrinsic with the market here whereas Trade 2’s are more extrinsic or out-of-the-money.

What that means is the difference between these trades becomes more clear though as we get closer to expiration. And that means the two trades need to be managed differently. The management also depends on what you want out of the protection. If the thought is that you want protection for the rest of the year, regardless of having gotten some downward protection to this point (or lower) then nothing needs to be done. Your best case scenario was always to be able to sleep at night on your long portfolio, knowing that if the shit hit the fan, you’d be protected. If your goal, however, was to trade out of the hedges or adjust them after getting a bit of a selloff, then time until the end of the year should start to come into your trade management thinking in the next month or so.

So with the SPY here, how would we think of these two trades? We think 1600 in the SPX is a very realistic possibility. We also think that a return to buying on dips is also a possibility, simply because we’ve seen it so many times during the course of this extended rally. With that in mind, what we’d be inclined to do on both trades is possibly buy in the 175 call if the market were to have another leg down to that 1600 level. If that happened in the next few weeks it’s possible that that call could be bought back to close for well under a dollar. This would be a great adjustment if your of the mind that after a selloff we could see a rally into the year end back near or above the highs.

If you think the high is in on the year, and 1600 isn’t necessarily a place the market will hold, you’ll want to let these trades ride a little bit. There’s no reason to take off these hedges. Trade 1 will work very well on the next move down as it’s already in-the-money and lower in the market and as we get closer to year end it will work as a 1 to 1 hedge from a delta perspective.

Trade 2 is a little more complicated in that it’s protection against a crash and is fairly far out-of-the-money even after this brief selloff in the market. Again, if the crash protection is what you’re there for, nothing needs to be done, but do know that since it is OTM, it’s hedging ability (the 2 dollars it has saved so far) becomes less and less the closer we get to year end without a sharp move lower towards or below 155 in the SPY. Therefore, if the market was below 1600 and the structure has taken alot of the bite out of the selloff on your portfolio, it might not be a bad idea at that point to take it off if you think the market is near a reversal point and could head higher into year end.