The S&P 500 has pushed to new highs and once again brushed off its recent minor slump. After April’s option expiration, I was left under-invested and needed to get some more skin in the game. My account balance has still been growing, thanks to TLT, but I knew I was missing out on more gains by leaving cash idle. Since I’m already up more than 6% this year and ahead of pace to meet my 2015 goal, I thought it would be wise to hedge my next trade and set myself up for lower risk gains down the road too.
I had no large-cap ETF exposure since I closed out my SSO naked puts last week. (I do have an in the money naked put on DIS, but consider Disney its own animal.) I decided to trade a combination of puts on SPY that will give me good upside potential and decent downside protection. While SPY was trading at $211.63, I bought one SPY March 2016 $215 put for $15.40 and sold one SPY March 2016 $195 put for $8.30. I paid $712.20 including $2.20 in commission. Since the long option is in the money, my downside protection is only 4.5% from where SPY was when my trade hit. However, I wasn’t hedging anything. If I only had this vertical spread in place, I would have been betting on a price drop.
To add in some risk and compensate for the cost of the hedge, I sold a put only 12 weeks out. Just 30 seconds after my first order hit, while SPY was trading at $211.60, I sold one SPY July $215 put for $7.00 and received $699.27 after paying $0.73 in commission. All three option legs combined cost me $12.93. My plan is to rewrite the near-term put three or four times by March 2016 and have my downside risk cut by 9%. I don’t expect a terrible bear market to hit us this year, so I might only need a hedge for the first 9-10% decline is stock prices.
Ideally, SPY will rise above $215 by the July option expiration and I’ll be able to rewrite a new put at the money and maybe only eight weeks out to push for a better annualized gain. If SPY doesn’t continue to climb another $3.40, I’ll have a 4.5% hedge and can write covered calls on my assigned shares to bring my cost down further. It’s kind of like I didn’t do anything today, but in three months, I’ll have a SPY $215-195 hedge already paid for and then I can start making money on new option trades.
I looked at the June $215 puts and at the $212 strikes for both June and July, but I wanted to come close to break-even on the cost of the hedge, so I went with the July $215 strike. Also, I entered the wrong number into my spreadsheet and I thought my annualized return was going to be much better than the June $212 put would’ve been. The July $215 put does offer a bigger annualized return than the June $212 put, but the June $212 put only give 0.22% more downside protection. For my needs, the July $215 put was the right choice to make, even though I thought I was going to have better potential than I will have.
SPY Naked Put Risk/Reward Breakdown
- Potential profit: $699.27
- Potential return: 3.36%, 14.21% annualized
- Breakeven price: $208.01
- Downside protection: 1.74%
- Recent high: $211.93, reached earlier today
- Cushion from recent high: 1.85%
- Expected support: The 10-week moving average is at $208.70 and is close to the low this week. I expect it to offer reasonable support coupled with the 20 and 50-day moving averages at $208.42 and $208.93 respectfully. Maybe the bigger indicator to watch is the trend line of higher lows that started in June 2012, yes 2012. This long trend line has only had a few short-lived breaks and is currently around $206.00 – 206.50, about 2.5% below today’s intraday high. The intraday low from March was at $204.12, almost 3.7% below today’s high and close to the normal mini-corrections we’ve been having for more than a year.
- Position close goal/limit: I plan to let this put run through expiration, unless I can roll it earlier for a good profit. I won’t lose any money until SPY is below $195 thanks to my hedge. So, I’m comfortable even taking the assignment if SPY doesn’t make it (and stay above) to $215. SPY bottomed just under $198 in mid-December and the beginning of February. I’d like to see those levels hold support again on any weakness, but can even stomach a 10% correction, to around $190.75. If SPY gets that low and shows signs of strength, it might be time to sell my long put for a profit and ride both of my short puts higher.