My Mini-Berkshire Strategy Using Options for Insurance

Using puts and calls to balance portfolio risks

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The main risk with this strategy is if the market declines below the strike price, and stays there until option expiration date. The put price will increase dramatically, and by expiration date I will be assigned the underlying.

However, using the example above, I would be essentially purchasing equities at a lower price than the cost at the time I entered into the options trade. I would essentially have to come up with $15,000 to purchase the underlying once it is assigned to me. In a margin account, I can take that 25% of equity and deploy it into the underlying on margin. I would have to pay margin interest to my broker for it, which could be expensive.

From there on, I have several options of what to do with the 100 shares of SPY for every naked put contract I have sold. I could either sell the shares in the market at a gain or loss, or I could sell covered calls at a strike that is at or above the price I paid for the shares. Since this is a trading strategy, I am not interested in buying on margin and keeping SPDR Trust in this portfolio.

My take will be to sell covered calls on the assigned shares at or slightly above the price I paid for them. If I got assigned at $150/share, I would either sell a covered call expiring in 4 to 6 weeks with a strike 150 or strike 151. My goal is to dispose of the shares as soon as possible, because I am paying a margin interest on them. The goal is to not sell shares at a loss. If I were unfortunate enough to sell SPY at 150, and the price fell too much under that price, I would probably extend the maturity by a few more weeks.

The worst risk I can think of with this strategy however is if my portfolio decreased by 75%, and my options get assigned at a price that is substantially higher than current prices. If that $60,000 drops to $15,000 and I have to spend an additional $15,000 to purchase stock worth $3,750 I might be close to getting a margin call.

The goal of investing is to minimize losses to principal that would result in a wipe-out of investor assets. I believe that by only allocating 25% of assets to this options strategy, I would have an adequate margin of safety that could provide some protection to principal. In addition, by using options that expire within a month or so, the risk of steep adverse declines are minimized. Stocks do fluctuate, but the likelihood of a 75% decline in one month is remote.

At the end of the day, this strategy would likely generate approximately $100 to $150 per month in additional income for a portfolio valued at $60,000, if a conservative 25% allocation to the strategy is used. While this is a small stream of income, over time it can turn into a small fortune by the mere power of compounding. If you set aside $100 per month and earn 7.50% annual total returns, you will have $17,793 in ten years.

Full Disclosure: Long MCD, Short SPY June $148 Puts


Article printed from InvestorPlace Media, http://investorplace.com/2013/05/my-mini-berkshire-strategy-using-options-for-insurance-spy-mcd-brk-a-brk-b/.

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