Protect Yourself Now Against The Correction

The markets had a remarkable month. Most major indexes are up 10-12% in the last few weeks. A correction seems inevitable. The question is not if, but when and how severe.

I would like to present a few ways to protect your portfolio before an inevitable correction. The Volatility Index (VIX) is at its lowest levels since mid-2011. That means that protection is cheap now. You should buy it when you can get it cheaply, not after the markets start falling.

So how much protection should you get, and how much can you expect to pay for it?

Assumptions:

You have a $100,000 portfolio which has a high correlation with S&P 500.

You want a full protection.

You expect a 5-7% correction in the near future and you want a short time hedge (6-8 weeks).

The most common way to protect such portfolio is using SPDR S&P 500 ETF (SPY) puts. If you have a more tech-oriented portfolio, you should use options on PowerShares QQQ Trust (QQQ). For a portfolio dominated by small caps, use iShares Russell 2000 (IWM) ETF. Those are extremely liquid and easy-to-trade vehicles.

Let's examine a few alternatives for how you could do it.

Alternative #1: Put Option

• Buy 7 March 130 puts

The first and most straightforward way is just buying SPY puts. Assuming you want to fully hedge the portfolio, with SPY currently trading around $132, you need about 7 puts. Looking at March expiration, you can buy those puts at $2.85. 7 puts will cost you $1,995 or 2.0% of the portfolio value and will give you a full protection starting at $127.15 or 3.5% from the current levels. All values are at expiration. If the SPY has a quick and volatile correction, the puts will provide very good protection. But if the correction is slow and takes more time, the puts will lose some value due to negative theta. If the correction doesn't happen, the entire premium will be lost.

Alternative #2: Bear Put Spread

• Buy 7 March 130 puts
• Sell 7 March 125 puts

The next option is buying a put vertical spread. If you expect a 5-7% correction, the most viable option is 130/125 March spread (Buy 130 put, Sell 125 put). You can expect to pay about $1.35 per spread or $945 for 7 spreads. This sounds better than $1,995, but your protection is limited to $125 level. If SPY trades at or below $125 by March expiration, your gain is $2,555 ((5-1.35)*7*100).

Alternative #3: Long Put Butterfly

• Buy 7 March 130 puts
• Sell 14 March 125 puts
• Buy 7 March 120 puts

Here you are buying 130/125 spread and partially financing it by selling 125/120 spread. The cost is only $0.60 per spread, so you will pay only $420 for this protection. Your maximum gain is $3,080. But here is the problem: the maximum gain is realized only if SPY is exactly at $125 at March expiration, which is not very likely. If it goes down to $125 and continues lower, you actually start losing money.

Alternative #4: Calendar Spread

• Buy 7 March 130 puts
• Sell 7 February Week1 130 puts

The idea here is to buy March puts and sell weekly puts against them every week. The March puts cost $2.85 and the weekly puts $0.56, so the initial cost is $2.29. If SPY stays stable or goes down slowly, you can keep selling OTM puts every week and recover the cost in 4-5 weeks. However, if the correction is quick and sharp, this protection will be less effective.

Alternative #5: Put Ratio Spread

• Buy 7 March 130 puts
• Sell 14 March 125 puts

The biggest advantage of this trade is that is can be done for a credit. Each 130 put costs $2.85 and each 125 put can be sold for $1.50. Since you are selling twice the number of 125 puts, you are getting a credit of $0.15 per spread or $105. If SPY is at $125 at expiration, the spread is worth $500, so the total gain is $3,500 plus the original credit. However, if SPY continues lower, you start losing money. In addition, since half of the 125 puts are naked, there are fairly heavy margin requirements to place this trade.

Alternative #6: Put Backspread

• Sell 7 March 130 puts
• Buy 14 March 125 puts

A put backspread involved being long OTM (Out of the Money) put options and selling ITM (In the Money) put options at a ratio, generally buying 2 OTM puts for each ITM put. The trade can be done for $0.15 debit (plus $5.00 per spread margin requirement). You should use this strategy if you expect a quick and sharp downward move. If this happens, the trade will be a nice winner. Increasing IV (Implied Volatility) will increase the gains as well. The gains are unlimited below the 120 level (at expiration). However, if the stock will slowly move towards the long strike (125 in our case), the trade will lose money.

As we can see, nothing comes free in options trading. Lower cost of trade will limit the protection to a certain level or range. The final choice depends on your market outlook and on how much you are willing to spend on the protection.

In my next article, I will examine a few ways to hedge the portfolio using Volatility S&P 500 (^VIX) index and iPath S&P 500 VIX Short Term Futures (VXX).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.