Using Puts Vs Stop-loss Orders To Protect Stock Positions – Part 2

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

In my last options article, I described two simple ways to limit losses on a stock or ETF position in case of a major down move. One way is to use a stop-loss order. The second is to buy Put options as protection.

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As a quick review, the pros and cons are:

Stop-loss order:

Pros:

• No cost to place the order
• Will usually remove you from the position at a price close to the designated stop-loss price

Cons:

• Can experience slippage (selling at a worse price than the stop-loss) which is unpredictable
• Ineffective in case of a drop that comes in the form of an overnight gap

Put Option:

Pros:

• Guaranteed to stop any further loss on a drop below the designated strike price, even in case of gaps

Cons:

• Must pay for the option. Put prices are high when markets are nervous.

Today we’ll look more deeply into the put alternative.

In the original article (referenced above), I used the example of a position in SPY, the exchange-traded fund that tracks the S&P 500. At that writing (September 11, 2018), SPY was at $289.33 per share. The put that we looked at as protection was the put at the 265 strike that expires six months later, in March 2019. That put was priced at the time at $4.91 per share. The 265 strike was chosen so that an arbitrary 10% loss was the worst case that we could have if SPY went down.

To re-state what the thinking behind buying that put was:

‘To buy that put, we would need to pay $491 in cash. We would then be guaranteed that we could sell the SPY stock at any time in the next six months for no less than $265 per share, or $26,500 for the 100 shares. In that worst-case scenario, the total drop in our net worth would be the decrease in value of the SPY shares of $2433 [$28,933 – $26,500], plus the cost of the put [$491]. So worst case, our loss from here would be $2,433 + $491 = $2,922. This is just about exactly 10% of the current value of $28,933. And it could not possibly be any worse than this, even if SPY should drop by 50% as it did in 2000 and again in 2007.’

It might interest you to know that buying puts on the shares of SPY can be used to protect the value of not just shares of SPY itself, but any stock or stock-like instrument (such as a mutual fund, etc.). The S&P 500 Index, on which SPY is based, is the benchmark for all stocks in terms of volatility. A readily available measure for anything stock-related is its Beta reading. You can easily find it for any stock or mutual fund by typing xxxx Beta into an internet search engine, where xxxx is the symbol for the stock or mutual fund you want. Typing in AAPL beta, for example, gives a result of 1.26 for AAPL stock. Doing the same thing with the symbol FSTMX (the Fidelity Spartan Total Market Fund) returns a value of 1.01.

The Beta for a stock or ETF is the ratio of that stock’s volatility to the volatility of the S&P 500 index. A beta of 1.26 as for AAPL means that stock has moved, on average, in the same direction as the S&P (because its Beta is a positive number, indicating a positive correlation); and that its swings tend to be 26% larger. Since FSTMX has a Beta of 1.01, it moves almost identically to the S&P 500. SPY has a Beta of 1.00, meaning that its movements should be identical to that of the S&P 500 index – as it must be, since the SPY fund owns those very same 500 stocks.

So, there is a global benchmark for volatility (the S&P 500); and there is a convenient underlying asset, with options, that precisely tracks the S&P – that asset being SPY. From this we can create a way to protect any and all stock-like investments using only options on SPY. We are not the first ones to think of this. The options on SPY are the most liquid and plentiful options in the world. Every conceivable expiration date and strike price is available, in large part because it is so convenient to use it to hedge almost anything.

Below is a table illustrating this with a portfolio of four separate assets: Apple stock; Exxon stock; and shares of two different mutual funds that an investor might have within a 401(k) program or elsewhere.

For each asset, we look up the Beta, and multiply that Beta by the Total Value owned of the asset. That gives an S&P Equivalent Value for that asset. We do the same for each asset, then add up the S&P Equivalent Values. In this case that totals $109,111. The actual values of the four assets total $99,150, but we want to know what the S&P Equivalent value is (also known as the Beta-weighted value). With that figure in hand, we simply divide by the current price of a share of SPY to determine how many SPY shares it would take to be equivalent in profit or loss to what the portfolio is likely to experience.

Making that calculation, in this case our $109,111 Beta-weighted value equates to 400.89 shares of SPY at $272.11 per share. Since each put option covers 100 shares, 400.89 shares / 100 shares per put = 4 puts.

We can buy 4 puts on SPY to protect this entire portfolio. If the stock market goes down, so will all of our assets and so will SPY, in a predictable relationship. When SPY goes down, the price of the SPY puts goes up, offsetting our losses on our four separate assets.

Exactly which SPY puts we choose to use, in terms of strike prices and expiration dates, depends on how much of the value of our portfolio we want to protect and for how long. Choosing a SPY strike right at its current price of 272 would give us maximum protection, at a high cost. Choosing a strike price that is lower will allow us to use cheaper puts. The tradeoff is that the puts’ protection won’t kick in until SPY drops to that strike; we are, in effect, choosing a higher deductible for our insurance policy in exchange for a lower premium.

Editor’s note: Online Trading Academy provides education in investing and trading techniques such as protection of a portfolio. They have brick and mortar centers around the world. For online information about the topic discussed in this article, visit Professional Options Trader program.

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