Equity bulls have been gifted with a stellar beginning to 2013. During the first quarter, the S&P 500 rose an impressive 10% despite continued angst over a host of issues ranging from the fiscal cliff and sequestration to emerging-market weakness and jitters surrounding the Cyprus bailout.
Since the dawn of the current cyclical bull market in early ‘09, it appears agile traders have perfected climbing the proverbial wall of worry.
And yet, with the current surge running long in the tooth and a seasonally weak period looming on the horizon, now might be a good time to make a few tactical adjustments to reduce your exposure.
It’s times like these where knowing how to use options can really pay off.
One of the simplest ways to minimize risk is buying put options. Kind of like buying insurance, long put options protect your stock positions from a market downturn. By definition, long puts give you the right to sell 100 shares of stock at a particular strike price on or before expiration. If your stock plummets, the put option will increase in value, helping to hedge, or offset, the loss in your position.
If you’re looking to protect a broad portfolio of bullish positions positively correlated to the S&P 500, you could consider buying puts on the SPDR S&P 500 ETF (NYSE:SPY). How much time you buy depends on how long you want to have the protection in place. If you’re concerned about a near-term pullback buying May options should suffice. To reduce the cost of the trade you could buy a put residing a few strikes out-of-the-money. With SPY currently at $157, you could buy the May 155 put for $1.85.
Click to Enlarge Another approach to buying protective puts is to focus on an individual stock position. Let’s say you purchased 100 shares of Yahoo (NASDAQ:YHOO) at $20 in January. With the stock having risen to $23.75, you’re sitting on a $375 unrealized gain. The risk graph of your position is shown to the right.
While you have unfettered participation to additional upside in YHOO, you also run the risk of giving back all your profits if it sells off alongside a broad market correction. To improve the position, you could buy the May 23 put for 95 cents. The long put would give you the right to sell your shares of YHOO at $23, which would lock in the majority of your current profit while allowing you to score additional gains if the stock continues trending higher.
Click to Enlarge The new position with the protective put is shown to the right. Let’s walk through how to calculate the amount of profit you are guaranteed at this point.
Since your cost basis for YHOO is $20 and you now have the right to sell it at $23, you’ve effectively locked in a $3 profit per share. However, we also need to take into account the cost of the put, which was 95 cents. If we subtract 95 cents from $3, your minimum profit in the trade comes out to $2.05 per share.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.