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posted on 19 October 2017

Using Options To Lock In Profits

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

The stock market has been on a tear this year, with the benchmark Standard & Poor’s 500 Index rising 14% for the year through October 11. Since the beginning of the current bull market in March 2009, the S&P is up by 239%, an average compound annual growth rate of over 15% for the 8-year period.

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If you haven’t achieved 15% per year on your investments over the last 8 years, don’t feel alone - virtually no one has. One would have had to know the exact moment to buy, and then to have held on ever since. Do you know anyone like that? Neither do I.

However, I do know a lot of people who, though not gaining 239%, are sitting on nice gains in the stock market. Perhaps you are one of them. In that case you face a pretty high-class problem - how to lock in at least a large part of those gains, but still participate if the market continues even higher. We’d all like to have our cake and eat it too. And to a degree we can, by using options.

I’ve written about this before, but here we are in this part of the cycle again. Over the next few articles we’ll look at some possibilities for taking money off the table after a big run-up without getting out of the game altogether. For all of these, we’ll assume that we have a portfolio of $250,000 worth of stock. This could be individual stocks or exchange-traded funds. Some of the choices apply to mutual funds as well.

How to use options to take profits during a market rally

Choice #1 - Keep Stocks, Buy Puts

With this choice, we keep the stock holdings, except for a fraction that we sell to raise cash to buy insurance on the rest. If stocks keep rising, we’ve only given up a little for the insurance. If they crash, we’re (mostly) covered.

One efficient way of doing this is to buy puts on just one underlying asset, that being the Standard & Poor’s 500 Index ETF called SPY, rather than on your individual stock/ETF holdings. Conveniently, since the S&P is the global benchmark for stock performance, every stock’s performance relative to that benchmark is routinely calculated and publicly available. It is referred to as the stock’s beta. The stock of Apple Inc., for example (AAPL) has a beta reading recently listed at 1.39. This means that on average, its volatility is 39% higher than that of the S&P.

Other popular stocks and their beta weightings are:

Exxon Mobil0.65
Bank of America1.29
General Electric1.08

Given the beta of each individual stock, ETF or mutual fund in your portfolio, you can easily calculate a portfolio weighted-average beta. For example, a portfolio that had equal dollar value investments in each of the above four stocks would have a portfolio weighted-average beta of (1.05 + 0.65 + 1.29 + 1.08) / 4 = 1.0175. If the total portfolio was worth $250,000, it would be equivalent, in terms of volatility, to $250,000 X 1.0175 = $254,375 invested in the S&P 500.

Since SPY is made up of the stocks in the S&P 500 index, owning shares of SPY is like owning the index; and owning options on SPY is like owning options on the index.

The price of SPY at this writing was $254.64 per share. If we divide our portfolio’s beta-equivalent value of $254,375 by the SPY share price, we get the number of SPY shares that would be equivalent to our portfolio. This would be $254,375 / $254.64 = 999 shares of SPY.

Since option contracts are in units of 100 shares, 999 shares / 100 shares per contract = 10 SPY put option contracts. Buying 10 puts on SPY would approximately hedge our portfolio.

At that time, the cost of options was at a near-all-time low, so the cost of puts was attractive. We could buy puts on SPY at the $254 strike, that would expire in March 2018, for $750 each. That would be $7500 for the ten puts, or $2.9% of the portfolio’s value. For that 2.9% we could insure against loss in the portfolio for about six months.

Insurance for longer periods is also available by choosing puts that expire farther in the future. Puts at the $254 strike that expired on September 29, 2018 were listed at $1,294 each. $12,940 invested in ten of these puts would insure the portfolio for about a year, at a cost of 5% of its value.

Purchasing puts would be one effective way to hedge our portfolio value at a fairly reasonable cost. It should be noted that like any insurance, it is cheap only when you think you don’t need it. If you wait until the market actually begins to drop, the price of puts will be much higher.

Note that mutual funds have readily available beta readings too. If you have a substantial amount of money in mutual funds in your IRA, 401(k) or other pension fund, you can calculate their equivalents and insure them with puts as well.

Using puts as insurance is just one way that listed options can be used by smart investors. To learn about others, look into Online Trading Academy’s classes on Professional Option Trading and Proactive Investing.

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