Strategies to protect your long Portfolio in case of a correction

Before and during a correction there are many interesting ways of using options to protect a portfolio. In this article I’ll present three different strategies with varying degrees of sophistication that are suitable for a very simple portfolio, a well diversified one, and an speculative strategy for those of you that just want to take advantage of downside.

Protective Collars

The first strategy is suitable for individual stocks or small portfolios. It is especially useful for stocks that have high implied volatility and trade well above 50. The trade is the following:

• Write calls against the shares, 90+ days and with upside strikes.
• At the same time buy catastrophic puts (same expiration than the calls). The strikes of the puts should be far OTM (very cheap)

The idea is to enter this trade at a very small premium or even a credit (depending on the price you can get for the calls).

The main drawback of this strategy is that if the stock rallies you will get your shares called away, however you will actually make money on the upside move but the profit will be capped at the strikes you sold. So you are sacrificing upside appreciation for protection.

The main advantage is that if a correction appears, the puts purchased will increase dramatically in value due to the downside action couple with an explosion in implied volatility, plus you get to keep the credit received for the calls.

You could repeat this strategy during the correction but being mindful of the potential violent bounces (you need to move the upside strikes even higher).

Dispersion Collars

For those of you with truly diversified portfolios it can be impractical, not to mention too expensive to protect each stock in the basket. So in this trade we take advantage of implied volatility dispersion between basket constituents and the index itself. In general index options carry a substantial lower premium than the sum of the individual option components due to dispersion effects, which are behind most of the modern portfolio theory. The core idea is that the risk of a diversified portfolio is lower than the total sum of risks for individual components so we take advantage of that situation to sell expensive IV and buy relatively “cheap” one.

The strategy is as follows:

• Write calls against shares of individual stocks, 90+ days out. Again the idea is to sell good juice here.
• Buy catastrophic Index PUTS (SPX PUTS) for the same expiration than the calls. These are far OTM strikes. Notice here how this long leg happens with index options.
• The correct ratio of calls to puts needs to take into account the beta of the stock and also the weight in the diversified portfolio.

The cons of the trade are basically the same than the protective collar one, plus the addition of an extra layer of complexity due to the computation of the correct ratio of calls to puts.

The advantage of the trade is that it should perform even better than the protective collar because it is taking advantage of the dispersion between the index and the individual members of the basket. During a correction the increase in value of the index puts should be very high due to volatility explosion and downside move.

Calendar Trade

The last proposed trade is for those of you that wish to speculate with downside action as well as higher implied volatility. The strategy is as follows:

• Sell an OTM SPX PUT around the target area you expect to see for the downside move. Use relatively near expirations for these (around 30 days or so).
• At the same time buy an SPX PUT with the same strike than the previous one but that expires 2 or more weeks after the first one (The longer the expiration the more sensitive the trade is to implied volatility).

This position is called a calendar trade and works really well for downside action because during  a volatility explosion the long put will appreciate faster in value than the short put. So in this trade we are collecting profits both on the direction of the move (towards our target) as well as the tremendous increase in implied volatility that accompanies such moves.

The cons of the trade is that is very sensitive to drops in implied volatility so for instance in a violent bounce up the position can lose value really quickly therefore it needs constant attention and discipline to maintain losses at an acceptable level.

The main advantage of the trade is that it can be done systematically during any bounces, and that the exit parameters are very simple, as the only thing required is tagging the desired strike.

Execution Notes for the Calendar trade

Given that the trade requires a short PUT during a period where the market is falling consistently we need to make sure that the trade is using European Style options, in other words we don’t want to be assigned on this short leg ever. That is why the trade works much better with SPX options (which are European style) than SPY options (which have American style exercise).