Are You Worried the Sell-Off Could Start Tomorrow?
In last week's Private Briefing, we outlined two options strategies that were essentially a pair of "insurance policies" for your stock-market profits.
The way we set them up, both strategies would allow you to continue to profit if stocks continued to advance, but would offset your losses should the broad market reverse course and fall.
Since we published the columns (on Aug. 22 and 23), U.S. stocks have done little to assuage the fears of those "top-conscious" investors.
Last week, even with a nice rebound on Friday, both the Standard & Poor's 500 Index and the Dow Jones Industrial Average ended their long winning streaks and posted weekly losses for the first time since July 6. And the tech-laden Nasdaq Composite Indexended its five-week winning streak.
Stocks haven't displayed a lot of strength this week, either.
Pundits and market mavens are now worried that market sentiment is becoming increasingly bearish - and that the "right" catalyst could trigger a sell-off that gathers both speed and breadth as it deepens. (A number of pundits have even said that U.S. Federal Reserve Chairman Ben S. Bernanke could inadvertently pull that trigger himself - tomorrow - by failing to make the "right" comments about the central bank's intentions when he speaks to a gathering of global bankers in Jackson Hole, Wyoming).
W e don't necessarily agree with that view here at Private Briefing. But we understand why folks are worried. That's why we decided to craft another "insurance" strategy, this time for investors with a more-bearish outlook.
To help us do that, I once again enlisted options expert and frequent Money Map Press contributor Larry D. Spears, the author of "Commodity Options: Spectacular Profits with Limited Risk" and "7 Steps to Success Trading Options Online."
Once again, Larry came through - in a big way.
"Bill, one way to achieve this objective is by making some minor adjustments to the triple-pronged protective-options strategy detailed here last week - adjustments that will give you unlimited potential profits on any downward market move, but provide a small and strictly limited level of risk if stocks should keep climbing," Larry told me. "Best of all, the cost to implement this modified strategy - based on Tuesday's closing option prices - would be less than $100."
[Editor's Note: These projections assume that volatility remains constant.] Let's use the SPDR S&P 500 ETF (NYSEArca: SPY) as a proxy for the U.S. stock market, just as we did with the strategies detailed last week (in Wednesday's "How to Play the Stock Market for the Rest of 2012" and Thursday's "Profit No Matter Which Way the Market Moves") . This exchange-traded fund closely tracks the S&P 500, but the ETF is priced at roughly one-tenth the current index value (plus a small premium for expenses). In other words, with the S&P 500 at 1,409.30 on Tuesday, SPY shares were quoted at $141.40.
Now let's say you want to set up a hedge against a bear-market -- to protect your money if the market falls sharply. Larry employs single contracts, and the option prices that were available at the market's close on Tuesday . ( In practice, you can make your play with as many contracts as you'd like, since these options are very actively traded.)
To create this hedge, you would:1.BUY one out-of-the-money September $140 SPY "Put" option , paying a premium of $1.83 a share, or $183 for the full 100-share contract. This option theoretically (assuming constant volatility) provides you with an unlimited profit potential if the market declines sharply.
2.SELL one out-of-the-money September $142 SPY "Call" option, bringing in a premium of $1.62 a share, or $162 for the full contract. Sale of this option simply reduces the cost of the play and helps define your risk.
3.BUY a deeper out-of-the-money September $144 SPY "Call" option, paying $0.76 a share, or $76. This Call provides your protection against a continued market advance, strictly limiting your loss at any SPY level above the call's $144 strike price.
The net cost of this position would be just $0.97 a share, or $97 for the full position (plus a modest margin deposit of $114). And it would leave you in a really nice position (see the "How to Beat the Bear Market" graphic above), as follows:
- Your potential theoretical profit would be unlimited, increasing steadily the further SPY's price fell below $140, though it would always trail the gains on a simple short SPY position by $237 (the $97 cost of the combo plus the $140 out-of-the-money amount on the September 140 put).
- Your maximum projected loss, suffered at any SPY price above $144, would be just $297 - regardless of how high the market might climb. For instance, if SPY rose to $155, you'd still lose just $297, compared to the loss of $1,360 you'd suffer had you sold SPY shares short.
- Your return on any profit would again be far higher than on an SPY short sale, which would require a minimum margin deposit of roughly $7,070 (and many brokers require more). If SPY fell to, say, $128, where it was as recently as June 4, your profit on the option combo would be $1,103 - a return of 1,137.1% on your $97 cost - whereas the short sale profit of $1,340 would represent a return of just 18.9%.
I did have one question for Larry: What happens if the " trigger" for a market pullback doesn't come between now and the Sept. 21 expiration of the options used in this strategy?
"If that happens," Larry explained, "you simply take your small loss and then position a new, bearish options combo using the October, or even December, options on the SPY."
You could, of course, use those longer-term options now, but the added time premiums will increase both the cost and the risk of the position. That's why we prefer to use the shorter-term options now, and repeat the trade with the next expiration month if U.S. stock prices remain near their highs.
This approach will let you more precisely position your play with the appropriate strike prices at that time, and keep your risk low.
Either way, if the correction you fear does come, you'll be way ahead of the game.
