Answering a Not-So-Simple Question

At some point, we'll get a meaningful pullback or perhaps more but right now, investors are wrestling with this uncertainty. This may be a bit harder on long-term holders who want to protect their positions, but not take themselves out of the game.

When I was asked about my thoughts on SPDR S&P 500 (SPY)put options this weekend by a colleague here who also happens to be a good friend, it got me to thinking about how a longer-term investor may want to approach hedging right now. We often build hedges with the hope we'll never actually need them. If this becomes the case, then we question why we even bought the hedges. Of course, hindsight is 20/20, so the first rule is to remember what the situation was when you bought the hedges, not the results.

So I was thrown a hypothetical portfolio (please see the attached table below) and simply asked if SPY January 2013 puts were worth it. It may seem like a simple yes-or-no question, but nothing in the market is ever simple. Are SPY puts even the right vehicle to use for hedges? I ran a three-year correlation on the portfolio against different iShares and indeed found the S&P 500 to be 97% correlated to the portfolio, so an argument could be made for using SPY puts.

Portfolio Vs. SPY -- Risk and Return Analysis

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The argument gets stretched a little when I saw the standard deviation of the portfolio was 20.18 against only 16.48 for the SPY, so it got me thinking on how to adjust for that little extra bit of volatility. It also got me thinking about how strong this portfolio had been against the market and the desire not to limit that too much.

In a portfolio like this, to protect it all by buying SPY January 2013 at-the-money puts, an investor would be looking at a cost around 8.5% before dividends. This isn't total protection, though, since the puts are only on the SPY and there are many individual names. However, the market has been strong, and the holder leaning bullish, so I would adjust that protection to 20% on the SPY rather than all the way to zero. In other words, I would use SPY put spreads rather than puts, so in this case, I would buy the SPY January 13 $136-$110 put spreads. On a $1 million account, that would mean I would need about 75 put spreads to cover a SPY drop of 20% from the current level through January 2013 expiration. Anything beyond 20%, and my coverage will have already maxed out.

Even using a put spread, the cost is still almost 5.5% of the current value. One approach to offsetting a portion of this cost is to write covered calls. Rather than writing covered calls on every holding though, I would only look to write covered calls on stocks that have traded at an annual standard deviation 150% or more of the portfolio's annual standard deviation or 200% of the SPY. These stocks should hold a higher beta and higher implied volatility, so there is a good chance that the premiums for out-of-the-money calls will be attractive, and I do want to use out-of-the-money calls. I actually want to go 10% to 20% out-of-the-money with expirations five to seven months out. By doing this, I leave more than half the portfolio open to unlimited upside and still give myself 10% to 20% upside on the stocks that have calls written against them.

If they get called away within the next six months or so, I shouldn't be too unhappy. The calls I have chosen net almost 40% of the cost of my put spreads, so now my overall cost to protect the portfolio via SPY put spreads is around 3.25%. Furthermore, this portfolio has a decent yield. In fact, over the next 12 months, there should be about $13,500 coming in from dividends. This now leaves my net cost even lower.

One important consideration on only writing calls 5 to 7 months out is these will expire or become exercised months before the SPY put spreads expire. If the calls expire, then I can simply write calls again bringing in more premium. If the calls are exercised, then I could look to sell some SPY put spreads since I may no longer require as much protection. And by not writing calls on all the stocks, including the SPY, I can consider writing calls against those positions if the market or an individual stock runs higher. There are plenty of options and opportunities here.

This approach doesn't eliminate all risk though, it only reduces risk. If the market falls more than 20%, then there is risk the portfolio will fall right along with the market. Even though this is a diversified group, single-stock risk still exists. If one or two stocks that make up 8%-10% of the portfolio fall sharply while the SPY rises, falls less, or stays flat, then the portfolio could start to underperform. The portfolio has shown greater standard deviation in the past, so one might consider buying 90 or 95 SPY put spreads to adjust for that greater standard deviation. If that were the case, then I could simply consider writing calls on a few additional stocks or even the SPY itself.

Overall, I find this approach much more appealing than simply buying puts and letting everything play out. There are a few more risks to this approach, but far more rewards and much more upside over the long term, which is what many traders with a portfolio like this are seeking.

At the time of publication, Collins was long SPY LEAPs and CA.