David Evanson and Oliver Pursche
Minyanville.com, Spring, 2013
Learn about a strategy you can use to get a little more upside, but protect yourself on the downside.
While the news is all pretty good from an investment perspective, we’re still in unknown territory. Continued monetary easing around the world may continue to drive markets up further. I, for one, think it will, but with the market at record levels after a 28% run over the past 12 months, I’d rather be a bit cautious.
One strategy you can use to get a little more upside, but protect yourself on the downside, would be to put a collar on the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which tracks the S&P 500 (INDEXSP:.INX). Here’s how you could do it.
If you’re not already long, go long on the S&P 500 and then sell the December 175 calls for about $3.65 per share (as of the close on May 21, and with 100 shares in each contract, about $3,650 per contract). In this part of the trade, you are selling another investor the right to participate in the upside of the S&P 500 at a level of 1775, about 5% from today’s level (a traditional covered call writing strategy).
Next, buy the September 150 puts for $1.60 (last trade on May 21). This gives you the right to sell the SPY at 1500 to the seller of the put. If the market drops, the value of the put will rise correspondingly (less time-value deterioration, which is currently minimal, and why the strategy is cheap to execute).
If you execute this trade, you will net $2.07 per share (or $2,070 per contract). Should the S&P rally another 5%, you risk the chance of getting called away, and losing the upside past 5%. (Of course, you can always buy back in.) If the S&P drops, the increase in the price of the put will protect you.
One note of caution: Given that the put option date is shorter than the call option date, it’s critical to review the position in early September and perhaps unwind the trade.
Finally, I’ve simplified this by putting a collar on the market at large with the S&P 500. The strategy can work wonderfully well with individual stocks, too.