The cost of Protection sets makes investors reluctant to hedge their portfolios. But then they regret it when a Black Swan Event happens.
While we ultimately still have to pay for this insurance, here are some techniques to make this cost more palatable.
When exiting trades, be careful about how to save a protection put. Instead of leaving the whole store, leave some guards behind for crash protection.
Some investors may sell cash-secured puts Acquire shares.
But why not buy a small 10-delta put as well?
This reduces the margin requirements and offers a bit of protection if something goes wrong.
When things are going well, you have some extra protection.
Date: 4th August 2020
Price: NFLX @ $ 509.64
Buy a September 18 NFLX at a strike of $ 425 @ $ 4,025
Selling an NFLX September 18th for a strike of $ 475 @ $ 14.05
Recognition: $ 1002.50
On August 26th, the trade made a profit of $ 717, which is more than 50% of the attainable maximum profit of $ 1002.50.
While the investor can close the entire trade and take the $ 717 profit, an alternative is to just close the short leg.
Date: 26th of August
Buy a September 18 NFLX at a strike of $ 475 @ $ 3,625
Direct debit: $ 362.50
Total profit so far: $ 640
The investor still has an NFLX with a strike of $ 425, which currently has a market value of $ 77 (too small to be sold).
It’s like the investor is receiving a free protection put that has a T + 0 line that rises when the NFLX falls.
This put option has gone quite a way out of the money to the 2.5 delta in 23 days to expire. However, the put doesn’t have to be in the money to gain in value.
Any drop in NFLX will be enough.
On September 3rd, NFLX had a bearish candle day.
The value of this protection put has increased to $ 171, an increase of $ 93.
The investor sells this protection put to get that profit.
Date: September 3
Selling an NFLX on September 18 for a strike of $ 425 at $ 1.705
Recognition: $ 170.50
Total profit: 811 USD (calculated from 640 USD + 171 USD)
This turned out to be more profitable than if the investor had completed the entire trade first with a profit of $ 717.
Some investors can use Back ratio spreads as a hedge against a market sell-off. Here is an example of the RUT (Russell 2000 Index) with crash protection down and no risk up.
Date: January 5, 2021
Price: $ 1979.11
Buy two RUT puts on February 19 with a strike of $ 1840 at $ 35.15
Sell a February 19 RUT put with strike $ 1980 @ $ 77.55
Net credit: $ 725
In this case the RUT continues to rise and the protection becomes weaker and weaker.
On January 20th, with a RUT of $ 2,160.62, the payout chart looks like this.
The price has moved so far that the market would have to fall by at least 12% for the crash protection of the back ratio spread to work.
At this point, the ratio spread has a profit of $ 275 and is a good place to close the trade and potentially get a new ratio spread.
Because the put back spread is a Bull put spread Plus an additional put option, the investor can simply close the bull put spread and keep the additional put as crash protection.
Date: January 20th
Sell a February 19 RUT put with Strike 1840 @ $ 7.85
Buy a RUT from February 19 with Strike 1980 @ $ 20.20
Net load: $ 1235
Now the investor only has one protection that offers immediate crash protection:
This February 19 RUT put option with a strike of $ 1840 and 30 days to expire has a market value of $ 785.
However, given the initial credit ratio spread, the investor only paid out $ 510 (calculated at $ 1235 minus $ 725).
More than half is good business. This only worked if the investor got good credit for the ratio spread and the market started to pick up again.
Here the long put in the back ratio spread was used as crash protection. But when it was no longer needed or useful, we redesigned it as a single protection put.
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Similar results can be achieved with the put broken wing butterfly that gets a good initial credit. For example,
Date: July 30, 2020 Price: SPX at $ 3,246.24
Buy a September 18th SPX with strike $ 3160 @ $ 78.05
Sell two September 18 SPX puts for a strike of $ 3220 at $ 96.75
Buy a September 18th SPX with strike $ 3250 @ $ 108.00
Net credit: $ 745
On August 12, the trade shows a profit of $ 435, which is more than half of the original loan of $ 745.
Instead of closing the entire trade, you leave all legs except the put, which is far from the money.
Date: 12. August
Buy two SPX puts on September 18 with a strike of $ 3220 at $ 38.30
I am selling a September 18 SPX with a strike of $ 3250 at $ 43.45
Net load: $ 3315
The investor now has a protective put with a market value of USD 3005. The investor paid out just $ 2570 (calculated at $ 3315 minus $ 745).
While we understand that we are only using the proceeds of a profitable trade to pay for the protection put; Psychologically, it feels a lot easier to do.
Does this work for Diagonals? Naturally. Diagonals are the most flexible two-legged option structure in the world.
Date: January 12, 2021
Price: QQQ @ $ 313.92
Buy 10 Mar 19 QQQ bets with strike $ 282 @ $ 5.52
ell 10 Feb 19 QQQ bets on strike $ 308 @ $ 8,265
Recognition: $ 2,745
On the January 22nd payout graph (shown below), this is a good point to take away winnings that hit $ 2330.
Instead of leaving the full position, the investor can keep half of the long puts for crash protection:
Date: 22nd of January
Sell five March 19th QQQ puts for $ 2 = 482 @ $ 3.30 Buy ten February 19th QQQ puts for $ 308 @ $ 3,715 strike
Direct debit: $ 2065
Receive total credit: $ 680 ($ 2745 – $ 2065)
The investor had received a total loan of USD 680 and still has five QQQ puts as of March 19.
The market paid for these puts. The value of those 5 puts at the end of February was $ 1,650.
These puts came in useful when the market fell and the QQQ closed at $ 314.56 on January 29th. The value of those five puts rose to $ 3,035. At this point the investor can sell.
Consider the following Iron condor that did not work
Date: December 16, 2020
Price: MA @ $ 332.10
Buy 10 MA Jan 15 put with strike $ 285 @ $ 1,155
Sell 10 MA Jan 15 put with strike $ 295 @ $ 1,815
Sell 10 MA Jan 15 call with strike $ 365 @ $ 1,375
Buy 10 MA Jan 15 call with strike $ 375 @ $ 0.69
Recognition: $ 1345
According to our rules for iron condors, we must take action if the short strike becomes higher than the 25 delta or if the price is within 3% of the short strike.
Both happened on December 30th when MA (Mastercard) closed at $ 355.55 and the Iron Condor was down $ 1,090.
The investor decides to close the position for a loss as MA is no longer bound by range.
Instead of closing all four legs, the investor is keeping the money out.
That put is worth $ 16 per contract at this point – not even worth selling.
Date: December 30, 2020
Buy 10 MA Jan 15 Put with Strike $ 295 @ $ 0.245
Buy 10 MA Jan 15 call with strike $ 365 @ $ 4,525
Sell 10 MA Jan 15 call with strike $ 375 @ $ 2,175
Direct debit: $ 2595 Previous total exposure: $ 1250
The remaining 10 puts still have a market value of $ 160 and will most likely expire when the money runs out.
However, you can get some profits back if MA decides to roll back at some point. When to sell is at your discretion.
For example, MA closed at $ 347.42 on January 5th. At this point, the 10 puts have increased in value to $ 640.
If you put them back on the market at this point, you will get:
Date: January 5, 2021
Sell 10 Jan 15 MA bets with strike $ 285 @ 0.64
Recognition: $ 640
Final profit / loss: – 610 USD (- 1250 USD + 640 USD)
The final loss of $ 610 is much better than if the investor closed the entire iron condor earlier for a loss of $ 1090.
Holding inexpensive long puts is not a big risk and can help you recoup profits in the event of sell-offs.
With a back ratio spread, keep an eye on the gain of the embedded bull put spread.
When it has made 50% of its potential profit, sell it and leave the long position as a hedge.
If the price of a butterfly with broken wings goes up without risk and moves too far from the butterfly’s body, take the trade for a profit, leaving the money farthest away. It’s of little value to sell anyway.
If you are selling a cash backed put, consider adding a long put that is far from the money, even if you plan to allocate the stock. In the event of a market sale, it acts as a lottery ticket.
If your trading structures are making good profits from market rallies, let some of the market money go towards paying your protection puts. Because of the market cyclicality, prices will reverse and then these puts will generate profits. And you don’t have to be in the money to do this.
While it is true that many of these puts expire worthless, in the event of a market crash it will be useful to have different puts spread and accumulated across different trades.
Disclaimer: The above information applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.