I’m not trying to sound the alarm and get everyone rushing for the exits, but according to the Shiller price-to-earnings ratio, the stock market is now the third most expensive it has been in history, behind only the market of 1929 and the dot-com bubble of 2000.
For those who are nervous about their long positions and want to find a way to protect against it in a relatively inexpensive manner, you may want to consider options trades, including what’s called a Protective Collar.
With these options trades, you first sell covered calls against your long position. You know this trade, as I’ve written about it frequently. Normally, you might do it to generate some income against a long position. However, in this case, you use the premiums generated from the sale of the covered calls to purchase puts against the same long position.
Thus, you give up the upside and should be able to offset against downside loss for a period of time.
Options Trades to Protect You: Home Depot (HD)
Let’s start with one stock I do believe is overvalued: Home Depot Inc (NYSE:HD). As I wrote in another article this week, I think HD stock is at least 20% more expensive than even the most aggressive valuation estimate. Thus, I think it is vulnerable to a downside fall, either from a large market correction, or just because the market may wake up and fix the problem on its own.
With Home Depot having closed at $147 on Wednesday, you could sell the 16 Jun $145 covered calls for $5.25, and then buy the 16 Jun $145 puts for $3.75. Thus, you first make $150 in net premium, which offsets a fall to $145.50. That leaves you only exposed for a 50-cent loss to $145, after which the puts will offset your long position at a 1:1 ratio.
Options Trades to Protect You: Starbucks (SBUX)
Some investors think that Starbucks Corporation (NASDAQ:SBUX) may have run its course for the near-term, as CEO Howard Schultz moves to the role of Executive Chairman to focus on new initiatives. At 30x net income, it’s also very expensive at around $58 per share.
There are many ways to play this, either selling near-term calls and buying near-term puts, or selling calls and buying puts for many months out. You could, for example, sell the 16 Jun $57.50 covered calls for $1.75, turn around and spend the same amount to buy the 16 Jun $57.50 puts.
Want to hedge your bets for an even longer period of time? It’s not unreasonable given the state of the overall market and particularly expensive state of SBUX stock. Maybe you want to sell the 15 Sept $57.50 covered calls for $2.80 and buy the 15 Sept $57.50 puts for $2.80, as well.
Options Trades to Protect You: SPDR S&P 500 ETF (SPY)
You don’t have to limit yourself to just doing this on individual stocks. You may be an ETF investor and only hold these diversified baskets of stocks. In fact, many of you may own the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). This popular ETF gives you exposure to the S&P 500 index itself. Why not hedge this important index if you own it?
SPY closed at $235.54 on Wednesday. You may want to sell the 16 Jun $235 covered calls for $5.25. Using that $525 in cash you get for selling the covered calls, you can turn around and buy the 16 Jun $235 puts for $4.65, and net $60 in cash.
You may want to sell the 15 Sept $235 covered calls for $8.15. Using that $815 in cash you get for selling the covered calls, you can turn around and buy the 15 Sept $235 puts for $7.95, and net $20 in cash.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. 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. As of this writing, he did not hold a position in any of the aforementioned securities.