Even though general economic conditions are currently relatively benign, the broad markets have seen some serious selling in the past six days, capped by a dismal day on Wednesday. The Dow and the S&P 500 both fell more than 3% and the Nasdaq shed 4% on the session.
During periods like this, investors who are still bullish about stocks in the long term still 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 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 - Free 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 closed at 23% on Wednesday, up 44% in a single day.
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 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, these 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.
Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.
Want more articles from this author? Scroll up to the top of this article and click the FOLLOW AUTHOR button to get an email each time a new article is published.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.