Investors have to deal with a lot of conflicting information right now. Stocks seem to have found their footing after March’s huge declines, but new headlines about the spread of the global Covid-19 pandemic and the collateral damage to the economy resulting from widespread business shutdowns threaten every attempt at a broad-based rally.
Unprecedented government stimulus that includes trillions of dollars’ worth of monetary and fiscal support promises to provide powerful fuel for a fast rebound when the crisis finally abates - but when that might be is anybody’s guess. In the meantime, the short-term news cycle is still a source of great uncertainty.
During periods like this, investors who are still bullish about stocks in the long term will sometimes start to think about ways to protect their portfolios from further declines.
Buying put options – either on specific stocks you own or on broad market index ETFs - seems like an obvious way to limit losses while still remaining basically long.
It’s probably not a good idea.
Let’s examine the nature of long put protection.
We’re used to buying insurance on all sorts of things. Home, auto, healthcare and life insurance are commonplace in daily life. If you insure other things that are valuable to you against unexpected losses, why wouldn’t you insure your equity portfolio as well?
Buying puts against a portfolio of long equities would work much the same way. You’d pay a periodic premium for the cost of the protection and be assured that the value of the portfolio could not go below the collective strike prices of the options you purchased. If it did, you’d have the right to sell it there, avoiding any further losses.
The problem with that theory is that it would be a constant drain on the returns of the portfolio. Options cost money - sometimes a lot of money.
It’s often noted that investors tend to ignore the compounding effect of dividends on long-term performance. Periodically receiving cash that can be reinvested is incredibly valuable for total returns.
Continually buying puts to protect stocks would act the opposite way – as a constant drag on returns in all market conditions other than a steep correction. Depending on the stock, it would cost 5% or more annually to continuously own 10% downside protection - and almost all of the time, that money would be completely wasted. Even in the event of a sharp correction, the investor would still absorb the first 10% of losses – even after having paid all those premiums that ended up being worthless.
It isn’t hard to see how damaging this approach would be for long-term performance.
What if you just bought the puts when the markets were looking shaky?
Unfortunately, that doesn’t work either.
For obvious reasons, market selloffs aren’t advertised ahead of time. Often, seemingly innocuous details can trigger a rash of selling that is followed by much more selling for myriad mechanical reasons. Prices in the options markets respond very quickly to these events and the price of options go up – way up.
The CBOE Global Markets (CBOE - Research Report) Volatility Index has traded around 12% for the last several years with an occasional spike during times of uncertainty. It’s longer-term historical average is closer to 19%.
The VIX has been trading north of 50% lately and has spiked over 80% during the height of the selloff.
During steep market declines, the implied volatilities of options increase as traders scramble to either cover options that they’ve already sold or buy to protect equity holdings. An automatic increase in implied volatilities as stock prices fall is built into almost every options valuation model.
Bottom line? If you were to buy put options now, you be paying significantly more than they usually cost.
Plus, here’s a little inside baseball – options market makers absolutely lick their chops when they get to sell options on days like Wednesday when implied vols have risen quickly. They end up short options at high prices and – perhaps counterintuitively – those options have lower gamma and thus are easier to hedge against losses. It’s not guaranteed to be profitable, but the odds are in their favor.
Do you really want to be on the other side of that trade?
Consider this instead. Let’s say you still have some cash on the sidelines and there are some high quality stocks you’re thinking about taking a position in now that they’re trading 10% or more off of their highs. Consider selling puts on those stocks.
We’ve discussed the concept before in Know Your Options, and the premise is fairly simple. When you want to purchase shares because the price of a stock has declined but the prices of options on that stock are also higher than usual, you sell puts instead with a strike price below the current price.
If the stock stays put or rallies, you get to keep the entire option premium you collected – which should be a handy profit given the inflated value of the options. If the shares continue to decline below the strike price, you buy 100 shares per option you sold, but at a lower price than they were trading when you initiated the trade plus you keep the option premium, further reducing the cost of the purchase.
It’s often assumed that selling options is overly risky, but if you sell puts on a stock you were going to purchase anyway, the trade actually has less risk than the outright purchase because in the worst case scenario, you own the shares anyway, but at a lower price.
Market declines can be unsettling and it’s understandable that investors might look to the options markets for some insurance, but it’s actually the worst time to buy puts.
If you’d rather sell securities that others are buying in a panic, selloffs can be a good time to do a little shopping for bargains and collect big option premiums as well.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
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