Using Options to Protect Against a Market Crash

We carry out a Bearish portfolio for our subscribers to follow (either by mirroring our trades on their own or having trades made for them by thinkorswim through its Auto-Trade program). Subscribers who follow this portfolio are happy campers this week. They made 26% on their money last week while most everyone else was suffering.

Today I would like to tell you how this bearish portfolio works.

Terry

Using Options to Protect Against a Market Crash

Our bearish portfolio is made up of put LEAP options that we buy (at strike prices which are higher than the current stock price) and short-term put options that we sell (at strike prices which are lower than the current stock price).  We use options on SPY so we are betting that the market in general will fall rather than just one individual stock.

The neat thing about this strategy is that if the market doesn’t fall (but stays flat), it also returns a nice profit.  It can even go up a couple of dollars and a gain should result.  Here is what the risk profile graph looks like for a typical bearish option portfolio using our strategy:

This is a Bearish options portfolio with $7000 invested.  This risk profile graph shows what gains or losses might come in two weeks at the August 19, 2011 expiration.

You can see that if the stock ends up flat in two weeks ($120.08), this portfolio should gain almost $1100 (17%).  If it should fall a couple of dollars, the gain should be about $1600 (23%).  No matter how far the stock falls in the two-week period, a minimum gain of $1000 should result.  That is just what happened last week when this portfolio gained 26%.

If the stock goes up $2, this portfolio also makes money (about 4% for two weeks).  A loss situation only results if the stock were to go up by about $3.  

An important part of this strategy involves making adjustments if the stock starts moving significantly in either direction.  Last week, when it started going down, we had to buy back short puts we had sold that had become in the money (i.e., the stock price was higher than the strike price).  We replaced these short puts with lower-strike puts (at strikes which were lower than the stock price).  This kind of adjustment tends to shift the entire risk profile graph curve to the left.

How many bearish investments can you make and still expect a gain even if you are wrong? Shorting stock only makes money if you are right and the stock falls.  Buying puts is usually a bad idea because they become worth less every day that the stock fails to fall.

A properly-executed options strategy can make big gains if the stock remains flat, smaller gains if the stock moves slightly higher, and very large gains if the stock falls. Where else besides options can you find this kind of opportunity?  If you know of one, please send it along to me.