This past weekend I spent some time working on formulas in a new spreadsheet for comparing different ways to hedge my account using the S&P 500 ETF, SPY. I came up with a plan and was excited about implementing it as soon as the market opened. However, by the time the market opened, I started to second guess my theory. Maybe because this is a very rare type of trade for me and maybe because the SPX opened almost 10 points higher and quickly was up by 15 points. My original plan was to buy enough puts to hedge my entire account and maybe a little extra (either five or six contracts). I planned to buy these as part of a wide vertical spread to lower my cost of the hedge (aka insurance). I estimated the cost to be somewhere between 1.7% and 2.45%, depending on what strikes I chose and how wide the spread was.
It was great in theory, I could eliminate any losses after a 7.73% fall until 18.23%. In other words, I could save 10.55% in a bear market if I spent enough to hedge all of the way out until June 2015. By the time I got close to choosing my updated strikes this morning and was close to entering my order, I remembered why I’ve hesitated to do this in the past. If SPY gains another 5-10% before falling back, my hedge would be the original 7.73% plus any gains after the order hit. My loss limit could quickly be 15%+ out-of-the-money if I didn’t make regular adjustments.
Instead of hedging my entire account, I decided to hedge half of it (actually a little more than half since the numbers didn’t magically line up for 50%). While SPY was trading at $189.59, I bought to open three SPY October $180 puts for $3.97 each and sold three SPY October $160 puts for $1.12 each. I paid $859.51, including $4.51 in commission for the three vertical spreads. Since I’m only hedging roughly half of my account, the insurance only cost me 0.83% of my account value. I’m basing the amount hedged on the (knowingly inaccurate) assumption that my entire account will move in unison with the S&P 500. If my entire account had a beta of 1.00 and if I had all $103,786.96 invested in SPY, I’d be 54.8% hedged. For this portion of my account, I’ll have 6.52% in losses in a correction before the insurance kicks in and then I won’t lose a dime until SPY falls beyond 17.07% lower. Since I’m only hedged for 23 weeks, the annualized cost for this protection would equal 1.87% of my account value. This cost is higher than if I had stretched the expiration into next year.
I opted to keep the expiration shorter because I don’t think stocks will stay flat for six months. By the time these puts expire, I will have either been able to use the hedge to save money or SPY will have moved higher and my hedge will be farther out-of-the-money than I’d like to make the hedge worthwhile. If we don’t get a solid 10% correction by the end of these contracts, I’ll re-write another vertical spread and will consider longer dated contracts. I still don’t think we’re in for a really bad bear market anytime soon, but we are long overdue for a move 10-12% lower. Still, that doesn’t mean it’s going to happen. I’ll just sleep better knowing I have insurance in place whenever it does happen.
Depending on how the market acts over the next three to four months, I’ll probably buy more vertical spreads at higher strikes to keep better asset protection. As an added bonus, my potential loss is less than the 6.52% I listed above. That’s because the positions I have open and the ones I will be opening in the months to come are with naked puts that have their own cushion built into them. If I sell a new put out-of-the-money I have a buffer of a few percent on most of my trades. That leaves me with a max loss of 2-4% for half of my account, until prices push higher.
Once I put a partial floor in place, I felt much more comfortable opening more exposure again. While SPY was trading at $189.51, I sold one SPY July $190 naked put for $4.38 and received $436.95 after paying $1.05 in commission. This trade brought me closer to fully invested, but I have $15,000 worth of other puts expiring at the end of this week, so I need to replace those with something new. I almost sold two SPY puts because the two naked puts would’ve paid for the three hedges and left me with one combination remaining to cover other positions. Since the July put I sold is for less than half the duration of the put spreads, I’ll have plenty of time to sell other puts that pay for today’s hedge trade before it expires.
SPY Naked Put Risk/Reward Breakdown
- Potential profit: $436.95
- Potential return: 2.35%, 12.36% annualized
- Breakeven price: $185.63
- Downside protection: 2.05%
- Recent high: $189.84, today – after I sold the put
- Cushion from recent high: 2.35%
- Expected support: $186.00 (where it bottomed last week), then $181.31 (the low since mid-February) and finally around $174 (the early February low).
- Position close goal/limit: Since I have the hedge in place, I can let this positions run even in the face of steep declines, but if I have an opportunity to close it early with a good profit, I’ll take it.
In my planning over the weekend, instead of selling a single July put, I thought about selling an equal number of deep in-the-money puts at the same expiration as the vertical spread. Using June 2015 strikes, I estimated I could produce a return of around 8% with only 7% downside risk. Running with double the money I have to back the naked puts could produce good returns with limited downside, but in a repeat of the last recession, I’d lose my shirt due to the limits of the hedge. Starting with a partial hedge seemed like the way to get some protection in place while the VIX is low. I’d like to add five to six month out contracts that cover half of my portfolio every three months. That should keep me covered for the next recession (even if it’s a couple of years away) and allow me to work half of the hedges higher each quarter or so. That’s the plan of the day, but it’s not anywhere close to being set in stone.