By, Dale Brethauer
Hello this is Dale, welcome to Part 2 of our discussion on hedging your portfolio with options. This is an investment strategy intended to offset potential losses. I have used this strategy in my own portfolio for over 2 decades on my path to financial freedom.
In this lesson we’re going to be talking about what type and expiration of option we should we be using and why. We’ll go over which ETF’s we should use as hedging instruments. We’re once again going to go over the hedging rules because the rules are very simple but very important. Then we’ll conclude by going over the entire process using my real 2016 hedges as an example. Let’s get started!
Okay. Let’s take a look at how far out we need to go with our protective puts. I just took some random years: 2008, ’10, ’11, ’14 and ’16. It looks like if we had protective puts during drawdowns that we’re about a month out, two months in 2008, we would have had the coverage we needed. Let’s use options that are about a month to two months until expiration. I think we’re going to be in good shape. Most of the times, I’ll go out a month, but if it looks like we’ve got a pretty bearish market, sometimes it makes sense to go out two months. You can always roll that over if it appears like we’ve got a weakening market.
This is an example that I just pulled out. This was back in September of 2014. At that point, the S&P was about 200. We wanted to put on a hedge. What I did is I went to the 17 October. This happened to be the monthly. You could use the weeklies if you so desire. What I would suggest if you do use the weeklies is you make sure you’ve got open interest of greater than 100. If you’re hedging with the QQQ’s or the SPY, these are pretty liquid ETFs. You should have no trouble with that.
You can see that this was in September. We went out to October 14 or October 17. This was about a month and a half or about 45 days out from expiration. Now, this is just an example. This was at the money at this point. This was September 2nd 2014, right around 200 at the money put would have cost you $3.22.
The other thing to notice here is it’s got a delta of .5. A delta of .5 means that for every dollar that the underlying moves, the ETF option will move 50 cents. What’s nice about that is if the market does go up, your portfolio will still increase in value because, remember, when we first buy this protective put, we really only have 50 percent coverage. You’ll notice this was September 2nd, and the SPY was at 200. Let’s take a look and go advance a little farther. Let’s go to October 7th when it had dropped almost seven points. It was at 193. You can see at that point in time the value of the option was $6.69. Notice here that the delta was one. Remember, that means for every dollar the underlying moves, the option moves a dollar. Now you’ve got 100 percent coverage. In other words, when you first put this hedge on, you’ve got 50 percent coverage. If it goes up, your portfolio will increase, just not as much as it would have if you didn’t have the protective put on. If it goes down and it continues to go down, you’re going to get more and more coverage for the same protective puts as the delta increases from .5 to 1.0.
Which one makes sense, in the money, at the money, out of the money? I choose at the money. You can see the value of the ETFs at that point in time, the ETF options. You can just go right to at the money. Those usually have the most liquidity.
This was just an example back in 2014 when the price was right around 200 at the money. You can see that the contract price was $3.22. If you would have gone about 2 ½ percent out of the money, it did drop in value to $1.75. Look at what happened to the delta. Now you’re only getting about 30 cents for every dollar move. You’re not getting the kind of coverage you’re getting ATM. If you want to get better coverage you can go down here to an in the money. This was about 2 ½ percent in the money. It’s going to cost you a lot more to get that initial coverage. It’s going to cap itself out when it goes down.
In the example we saw, it went down about seven points. This went from a delta of .77 to 1. You get basically more coverage at the money. It went from 50 cents to a buck. Out of the money never did quite get there. You got more bang for your buck here at the money. You got more profit at the money than you would have with the other two. You’re not only getting more profit potential, but you’re getting the best coverage. I like at the money about one to two months out.
This is a risk profile of an at the money protective put. What this risk profile is showing you is that if the market does go up, if your portfolio is up, you’re capped here. You can’t lose any more than what you paid for those protective puts. That’s the insurance you’re going to pay. If the portfolio starts dropping, look at how you’re going to increase with those protective puts to counterbalance what’s happening within your portfolio.
Which ETFs to use. Now, there are over 7,500 publicly traded stocks. If you go with the SPY, which is the Standard and Poor 500, if you go with the QQQs, which is the NASDAQ 100 and you go with the IWM, which is the Russell 2000, you basically have 2,600 of the stocks out of there of 7,500. You’ve got the majority of them covered. Those are the three ETFs that I use. These ETFs are very liquid and very highly traded, giving good bid-ask prices.
How are we going to apply this? What you want to do is you want to get your latest portfolio statement that shows your positions. I just took a screenshot here from Think or Swim where I had Apple, Clorox, Home Depot, MacDonald’s, the SPY, AT&T and Verizon. These are all Standard and Poor 500 stocks. This was relatively easy. This portfolio was about $96,000. Let’s round it up to $100,000. SPY ETF at that point in time was about $200. There are 100 underlying for every contract of options. I only needed to get five SPY option contracts to fully cover the portfolio. I’m spending about $3,000 of insurance money. That’s if I let it go all the way to expiration. Well, if the market goes against me, I’m neutral because that means my portfolio’s increasing in value. If the market drops, I’ve got that protection that continues to increase in delta as the market goes down to protect my portfolio even more.
Are your stocks in the NASDAQ 100? Are they in the S&P 500? Are they in the Russell 2000, the mid-caps? I total how much of the portfolio size is and then I determine how many protective puts I want to buy in those ETFs to cover me in case of a drop.
Let’s go over the rules one more time. We did that in Part I, but I think it’s worth going over again. You can print this out with a screenshot. I think this is pretty easy to see. We’re going to start right here in this box. If the price closes below the eight-day exponential moving average line, I want to put a hedge on. If it continues to cross below the 21-day, yes, I’m going to keep the hedge on.
When the eight-day crosses above the 21-day, I’m going to take the hedge off. As long as I stay below here and then cross below here, I’m going to keep the hedge on until the eight-day crosses over the 21-day and I’m going to take it off. Now, let’s say it closes below the eight-day. The hedge is on, but it doesn’t close below the 21-day. Now the price closes above the eight-day, I’m going to take it off. The eight-day exponential moving average line is the important line. That’s our trigger to get in or get out.
Remember I always look at the close. At the end of the trading day, you just look at this and say, “Well, did I close above or below the eight-day?” If I close below, it kind of peaks your interest to say, “Hey, something might be happening here”. What you want to do is look at the chart and say, “Does this look like it’s starting to roll over?” If it’s starting to roll over, you might watch it for a couple of days. If it continues to roll over, go ahead and get your hedge on.
I showed you earlier on it’s not critical that you jump right in there right away as soon as it drops below the eight-day. That basically is piquing your interest at that point and now you want to watch the market pretty close. If you think it’s going to be heading on down, that’s when you put your hedge on.
Don’t worry if you put the hedge on and buy those protective puts and then the market turns around and goes up because your portfolio is still going to be making money (net neutrality), only half as much as what it was when you didn’t have the protective puts. This is a wonderful strategy.
Okay, here we are. It dropped below the eight-day. I was watching it real close. This is a pretty good drop.. It closed below the 8 day EMA, so I went ahead and got in and put a hedge on. Then it went back up but then the next day came back down. It tried to go up again. The next day it came down. Then it had its drop. This is the drop that we would have lost quite a bit in our portfolio. The SPY at that point was 210. It dropped all the way down to 195. That was about an eight-percent drop. That’s a reasonable correction. Do you want to take it all the way down with an eight-percent loss? No. If we would have hedged that, you would have come down here and been just about even and then bought more shares so that when this run happens here and takes you back up to where you were before, you’re going to be making more money. If you just held on to your portfolio and let it drop down here and lost and came back up and said, “Okay, now I’m breaking even”. With hedging you’re not breaking even. You’re making money going down, you’re reinvesting it and you’ve got more shares as it comes back up.
There’s really no way to lose here. That’s the beauty of this strategy. If you think the market’s going to go down and you buy protective puts and the market goes up, your portfolio increases in size. If the market goes down, you’ve got it protected. It’s a win-win strategy to protect your hard-earned money in your portfolio.
Once again, this was back in 2016. On December 16th, the SPY was at 205. If we were just trading the SPY, we would have had 488 shares, 205 divided into $100,000. We had a $100,000 portfolio. Remember you can use these calculations for any size portfolio you have. Just change the numbers. We had 488 shares. We want to protect that. All we needed is five February 2005 puts and we got those for $6.38. That’s 3.2 percent insurance, but remember we’re never going to let it go all the way to expiration and have it drop from $6.38 all the way down to zero. That wouldn’t be right because if we’re heading back up, I’m going to get rid of that protective put. Ultimately, I’m not going to let it go for a month. I’m not going to let that go to zero and spend the whole 3.2 percent for the insurance.
Now, the market did drop here. It went from 205 to, let’s see, it went down to 185. That was about a 10 percent drop. Eight to 10 percent, those corrections happen all the time. One to five percent happens many times during the year. Eight to 10 percent happens maybe four times. More than that, you’re getting into a major correction, and they don’t happen that often, especially during a bull market.
On January 20th, we sold these protective puts for $19.42 and took that $6,520 and bought more shares. The shares were cheaper. They were only $185.50. We bought 35 additional shares and now we had 523 shares. Our portfolio was about the same size. We’re ready for the next run. We’ve got 523 shares working for us now rather than 488. This is the way you compound. You compound and use the money that you made on your protective put.
In conclusion, I want everybody to protect their hard earned portfolio by hedging against downside snaps and larger moves (2008). You want you to protect your portfolio by hedging. Now, this is usually people that have a relatively good size portfolio. Let’s say anything over $50,000 is worth protecting by hedging with ETFs. You don’t want to see it drop. Protect it with protective puts. When it drops, go ahead and sell those puts, take the money you bought on the protective puts, buy more shares in your portfolio so when the market goes back up again you’re going right along with the market with more shares in your portfolio. I hope everybody takes advantage of this. This is the way I protect my portfolio. I’ve done this for many years.
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