Puts and Calls: Market Hedges for Volatile Times

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The market has been pretty scary the past two weeks. The volatility has been so insane that we’ve seen market movements of years occur in a matter of minutes. This is likely to be the new normal, as computerized trading and algorithms, ramp up the speed at which trading occurs.

Puts and Calls: Market Hedges for Volatile Times

It can cause a lot of stress for investors, especially those who don’t use puts and calls as market hedges. The best defense is to own a broadly diversified long-term portfolio in which big moves are smoothed out over long periods of time, and diversification prevents any one sector from wiping out your entire portfolio.

Even if you are a long-term investor, though, or if you have some other kind of portfolio, you still might have a few concerns about volatility going forward. After all, if nothing else, even conservative investors dip into aggressive short-term plays for growth here and there.

Well, regardless of what direction the market goes, puts and calls can help you hedge your portfolio. Here are three ideas on how to hedge the market, all via puts and calls on the SPDR S&P 500 ETF (SPY).

Puts and Calls: S&P 500 Scenario #1

At Monday’s close, the S&P 500 was trading at 1,972. That index is best mirrored by the SPY, which is 16% off its all-time high. You may choose to buy puts on the entire index as a way to hedge against the entire market dropping.

Even if you don’t own the S&P 500 in some form, hedging against the market is one way to offset possible portfolio losses if the market falls again.

Puts and calls are one way to play this hedge. Let’s say you are nervous enough to want to hedge into mid-November. The SPY bottomed during the correction at about $187, and you’d like to hedge against a fall that takes it below that. Consider buying the Nov $194 puts for $7.32.

This effectively costs you 3.7% to hedge against a fall of greater than another 6% or so.

If you think it’s worth it, go for it.

Puts and Calls: S&P 500 Scenario #2

There’s another approach you can take. Let’s say you own the SPY, and while concerned about a decline, you’d rather not spend the money. If you are willing to possibly give up some upside if the market significantly recovers, you can use puts and calls.

In this case, you can sell the Nov $197 calls for $7.65. Then, turn around and use the proceeds from that sale to purchase the Nov $194 puts as above. It does not cost you any money out of pocket to finance the hedge. However, you are potentially giving up some upside. If the SPY rises above $197 and stays there until Nov. 20, you will have the stock called away and miss out on the gain.

Of course, nothing stops you from buying more at any time along the way.

Puts and Calls: S&P 500 Scenario #3

You could also try the reverse of this strategy using puts and calls to give you some upside gain without committing too much extra capital if you think the market has sold off too much.

In this case, you might sell the Nov $194 puts for $7.32, then use the proceeds to purchase the Nov $197 calls for $7.65. You’ll have to finance the other 33 cents for the call, but that’s not much at all.

With this strategy using puts and calls, you are betting that the market is more likely to go up than down. You sell the puts, meaning you could get forced to buy more of the SPY if it falls below $194, so that’s your risk. However, if that doesn’t occur, you will benefit from the SPY going up by owning the call. If it closes above $197, you will make money since you financed the call purchase using the puts you sold.

Puts and calls are great ways to make bets on the market without exposing yourself to too much risk. Consider them if you are feeling jittery, but remember, a long term diversified portfolio remains your best route to sleeping well at night.

Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold SPY nor any derivatives of it. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/09/puts-and-calls-market-hedges-spy/.

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