Using Put Options To Protect A Portfolio Of Stocks

*** The following is a guest post from Gavin McMaster founder of Options Trading IQ ***

Markets took a beating recently due to the coronavirus outbreak and while they have recovered slightly, I thought it would be a good time to look at how to use put options to protect a portfolio of stocks.

The S&P 500 peak in mid-February at 339.52 and subsequently fell to a low of 2,191.86 on March 23rd. That was one of the most severe and rapid declines in market history. The 35.41% decline took a lot of investors by surprise and saw the portfolio gains from the last few years evaporate.

What Is A Put Option?

Put options are securities that are used by hedge funds, money managers and professional traders to protect their portfolios from drawdowns like the one we saw recently.

Investopedia gives the definition of a put option as:

“….a contract giving the owner the right, but not the obligation, to sell, or sell short, a specified amount of an underlying security at a pre-determined price within a specified time frame. The pre-determined price the put option buyer can sell at is called the strike price.”

Basically, what that means is that put options give the owner the right to sell their stocks at a certain price, no matter how low they go.

Think of it like an insurance contract that protects you against the worst-case scenario. Just like an insurance contract, you need to pay a premium for this right.

How Do Put Options Work?

Put options will increase in value if the underlying stock declines in price. Assume XYZ Corporation is trading at $100 and an investor owns 100 shares and wants to protect their capital below $95.

To do this, they could buy a three month $95 put option and might have to pay $3 for this contract.

If XYZ runs into financial difficulty and goes bankrupt, their shares go to zero.

Thankfully for our investor, they own a put option at $95 which gives them the right to sell their share for $95 even though the value of the shares has gone to zero.

In this case, the investor has lost a total of $8. That’s $5 for the decline in share price from $100 to $95 and the $3 in premium paid to purchase the put option.

This strategy is a risk management strategy known as a protective put and is used extensively by investors with large portfolios. By implementing this strategy, they know in advance what their absolute worst-case scenario is.

What’s The Downside?

Buying put options is a great risk management tool, but like any investment strategy, there is always a risk.

If XYZ doesn’t drop and instead remains at $100 when the option expires, the investor has effectively lost 3% due to the put option they own becoming worthless. In this case, the investor would underperform someone that didn’t use this protection strategy.

The same can be said if XYZ rallies. The protective put strategy will always underperform by the cost of the put option during a bullish run. But they can still be worth it for peace of mind.

Real-World Example

Let’s look at a real-world example. For simplicity’s sake, let’s say that an investor owns 100 shares of SPY as their portfolio.

With SPY trading at $287.60 that represents an investment value of $28,760.

If SPY dropped 25%, the investor would lose $7,190.

A July 17th $260 put option is trading around $13. If the investor were to buy that put option they would be able to sell their shares for $260 no matter what happens.

The table below shows how the protective put strategy compares with outright stock ownership.

Volatility is pretty high right now which means put options are expensive. When markets are calm, put options a lot cheaper. That $260 put might only cost $6 instead of the $13 it currently costs.

Summary

    • Buying put options is a protection strategy used by money managers and professional traders.
    • Put options can limit the downside risk on a stock or portfolio of stocks.
    • Put options become more expensive when market volatility is high.

Thanks for reading.

Gavin McMaster

Options Trading IQ

Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Gavin has written 8 books on options trading and you can find more from him at www.optionstradingiq.com

How We Find The Ideal Trading Strategy For Different Market Regimes

Knowing how to trade in different Market Regimes is just as important, if not more so, than what to trade. So what is a Market Regime?

A Market Regime is a quantified method of organizing the characteristics of different trading environments. We have five:

    • Bull Volatile
    • Bull Quiet
    • Neutral
    • Bear Quiet
    • Bear Volatile

Each regime is a measurement of direction of travel of the underlying asset, Bullish, Bearish or Neutral.

And further organized by Volatile or Quiet.

This is measured with a tool called the System Quality Number (SQN) you can view a video about it here. The SQN measures the average % change from close to close of the previous 100 days and then square roots it. This is how we quantify bullish or bearish, if the change is positive on average for the past 100 trading days, that’s bullish and likewise bearish if negative. Then as the % change increases it becomes more volatile and decreases that’s less volatile. A nice quantified methodology to measure.

This methodology is trailing, so the SQN is a trailing indicator, and that’s important to note. The SQN isn’t there to be a holy grail super classified highly fragile high win rate indicator that will tell you when to buy the next 24% up move or to short a market meltdown.

Rather it’s more like a calendar. If you know that it’s January and you are in Montana, you are more likely to need a heavy coat, boots, hat, gloves and you can pretty much be guaranteed you won’t need a tank top and flip flops.

The SQN is similar because now we can quantitatively recognize the “season” we are in. Like a Calendar would suggest it’s winter and you know you are in Montana, the SQN is saying we are in Bear Volatile regime so let’s get the appropriate tools (attire in this analogy).

Let’s jump in to this week’s action.

SQN Indicator on daily S&P500 Chart

Looking at the S&P 500 index on April 6, 2020, this week’s market action is characteristic of the transition between Bear Volatile and Bear Quiet regimes. It gets tricky in here as optimism starts to kick in as we rally from the depths of hell back to where we are now.

Bears are nervous and are covering their shorts or waiting to cover their shorts, bulls who got punched in the throat last month and sold at the first bounce are starting to wonder if they did the right thing and start buying. This is what fuels bear market rallies, the most violent of all rallies.

As you know we aren’t here to call bottoms or tops, we let the market regimes guid us. What works in a Bull Quiet regime doesn’t work in a lot of other regimes and what worked in Bear Volatile doesn’t work as well in a Bear Quiet and vice versa.

As part of the mentorship program I am running currently, AKA the Trading Thunderdome, we are doing extensive work on finding characteristics of the different market regimes and corresponding strategies to perform in the different regimes.

In order to get accepted into the Trading Thunderdome program you need to have completed the Systems Building/Backtesting Mastery Course to ensure that you have the proper tools and skills to benefit from the course.

We will be releasing the formal program soon…

We will be running these programs throughout the year, so if you are interested in doing the intense work to become a successful trader, get that course. It’s 1/2 off right now!

Grant, who is currently in the program did some great work on finding a system that performs quite well in a Bear volatile regime. He settled on the ES (S&P 500 Emini) using the Vol Breakout Short only strategy on 60 minute charts, however lower time frames are equally as good.

And here’s Grant to show you what he discovered…

Hi Traders,

Grant again, one of these days we will do a more formal introduction. However, right now we are going to discuss the how the Volatility Breakout performed on an hourly chart during the Great Financial Crisis of 2008–2009. We will be working through the process of improving this system so that all of you out there will understand how to test systems or ideas.

So, let’s get started.

What is a Volatility Breakout or VBO for short? This is a setup where the Bollinger Bands are within the Keltner Channel signaling a low volatility regime. One of our beliefs is that volatility moves in cycles from low to high volatility and back again. Therefore, we want to see a price breakout above or below both the Bollinger Bands and Keltner Channels. When that bar closes, we place a buy or sell stop above or below the breakout bar. This is a trend-following strategy so we would expect a lower win rate to the FVBO system. However, in certain regime we see the VBO strategy shine. Specifically, the bear volatile regime.

Backtest Notes

1) 12/13/2007–3/6/2009

2) We only took Short VBO Trades

3) All stops were based on the bar close

4) 20-Day EMA Trailing Stop

5) All trades were entered between 7am and 4pm EST

Now that you get the gist of the strategy, lets look at the raw numbers. Also I’ve provided a link to my backtest in Google Sheets, you can take this spreadsheet, make a copy and it’s yours!

Backtest of 2007–2009 Short Only Bear Volatile VBO here

The first thing to note is that this strategy provides a fair number of opportunities. This is important because we want the law of large numbers to work in our favor. The more opportunities we see the greater chance we meet the expectancy of the backtested data.

The next thing I want to draw attention to is the win rate; 61.5%!!! For trend-following systems this is unheard of. Good trend-following systems win just about 40% of the time. This should ring massive church bells in everyone’s head… market regimes matter to strategy selection.

Finally, this system has positive skew. That just means we make more money on winning trades than we lose on losing trades. This provides robustness to the VBO strategy and is important factor in its profitability.

Thanks Grant!

He is doing great work.

And finally now that we had Grants backtest of our “training data set” 2007–2009 Bear Volatile regime, I went and used “test data” of March 2020 Bear Volatile regime and did a ‘hasty backtest’ live on YouTube this morning

The results were very similar for me, though it was just a few weeks of trading.

That’s it for today, best of luck all.

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