7 ways to protect against market turmoil
Summary: A recent poll by Saxo Bank showed that a large group of investors do not fully trust the current price levels. Is that a reason to sell? No, but protecting your investments would be the smart way to go. Below are several option strategies that could provide a safety net for your stocks in case of market turmoil.
Naturally, you would only apply the following strategies if you are confident that your stocks will appreciate in the long run. If you believe that a particular stock will fall and will be lower in the coming years, then you may simply want to close the position.
Strategy 1: Cash is king
Take a broad look at your total portfolio and forget about the original purchase price. Actually, look at your total net worth because your overall capital value should be leading. And be aware, selling a particular stock will not affect your total capital, except for transaction costs. You can see your total capital as the summary of your portfolio at the highest aggregation level. With this approach, you rise above the level of your individual current holdings and this insight can help you to make the changes you want.
Look at your portfolio in the following way: if you had the value of your current portfolio in cash and you were going to invest, would your portfolio look exactly like this? If you are completely satisfied, no action is needed. If you are not, make the changes that will heighten your comfort level. And the easiest way to do this is to turn your equity holdings into cash. Do you prefer to lower the risk of the portfolio by 50%? Then halve your position.
Strategy 2: Exchange shares for long-term calls
What is the benefit of this strategy? You know that when you buy a call, you must pay a premium. But this is also your maximum loss! If you buy a share at € 15, then you can lose € 15. You can also choose to buy a long-term call that is in the money. For example, the call with a time to maturity of 2 years and a strike price of 12 (you have the right to buy the shares for € 12 for the coming two years) will cost (depending on the volatility) €4. This €4 is your maximum loss. If the stock drops from €15 to €7.50 and you own the shares, you will lose €7.50. The bought call option will also decrease in value of course and maybe it will only be worth € 1,25. You will make a loss, but this is much less than the €7.50 you would have lost in the shares. And if the stock price rises, you will benefit via the long call.
Strategy 3: Sell a portion of your shares and write puts
Imagine, you own 1,000 shares that are now worth €20. While you have confidence in the company, you also see that the stock falls when the whole market falls. And you see some dark clouds for the market in general. What you can now consider is to sell half the shares and at the same time write 5 put options (sell 5 put options) below the current stock price. If the stock goes up, you will earn from the 500 shares you still own. You can also label the received option premium as a profit because they will expire worthless. So, you're doing a good job when the market rises again. However, if the stock drops further, you will be obliged to buy the shares at the exercise price of the put option you sold. But this means that you buy the sold shares back at a lower level than the original sell price. You have, as it were, skipped a part of the decline.
Strategy 4: Write a call on stocks in your portfolio
If you write a call, you enter an obligation to deliver. For a lot of investors this feels annoying because this hinders the upside potential. The question is whether this is really the case. Assume a share is trading at €10 and the call with strike price 11 that quotes € 1. If you write this call (one call per 100 shares you own), you have built up a buffer of € 1 for a decrease in that stock. That is not enough if the share loses 50%, but it is better than nothing. And if the stock goes up, you can do two things. The first option is to do nothing and then deliver at € 11 (effectively at € 12 because of the € 1 option premium received).
If you don't want to deliver the underlying shares, you can roll the written call to a higher strike price. The time to do this is when the written call is At The Money. For example, if the price has risen to €10,95, it's time to think about rolling the written call. The reason to do it when the call is At The Money, is that you will be able to do it with a credit. You roll the C 11 to a C 12 with a longer time to maturity. By rolling when the stock trades around the exercise price, you will have to pay less for buying back the call than you receive for the call you will sell. You can repeat this rolling if it fits within your vision.
Strategy 5: Protect your shares by buying put options
A lot of investors know the way put options work. By buying a put you get the right to sell the underlying for the strike price until expiration of the option. At the same time, a lot of investors find puts too expensive. An At The Money put option could easily cost 8% - 10% (of the underlying) and in a high volatility environment this percentage could be even higher. So, buying puts can protect your shares, but it’s an expensive solution. A slightly cheaper possibility is buying a put spread instead of an individual put. The investment is smaller, but the protection is also limited.
One way to solve the high price for protection is a combination of strategy 4 and 5: the collar.
Strategy 6: Protect your stock investment with a collar position
In this strategy, you write an Out Of The Money call and buy a put option from the proceeds. This means that you enter into an obligation to deliver a higher level (written call) but at the same time you have the right to sell the underlying at the strike price of the put option (bought put). You limit your upside potential but also your downside risk. This is an appropriate construction for investors who want to reduce their risk.
Strategy 7: Write both call and put options
This is a combination of strategy 3 and 4. Assume the starting position is long 1,000 shares without any options. What you can do is to sell 500 shares (half of your position), write at the same time 5 puts with a lower strike price and sell five calls at a higher strike price. The option premium you receive for both calls and puts is a buffer for a moderate decline in the share price. And again, if you are not bullish on the stock in the long-term and afraid the share prices may really plummet, sell all your shares.
If you apply this strategy, you have entered into the following position: long half of the shares you originally owned, an obligation to buy at a lower level than the current price and an obligation to deliver at a price higher than the actual price of the shares.
If the stock falls, you will be required to buy 500 shares at a significantly lower level than at which you sold them. And if the stock goes up, you either roll the written call as discussed in strategy 4 or you deliver the shares at the strike price of the call option you sold.
Remember, stick to your size (especially in naked put option writing)
If you follow the strategy of selling naked puts in order to receive the premium and without the desire to actually buy the underlying shares, make sure you keep your size in check. Too often, investors only look at the margin obligation that writing options entails. They forget to look at the actual risk involved. If the share is €10, the margin obligation of a naked short put might be € 150. This may lead to investors selling too many puts because they can easily comply with the margin needed to do so. Nothing to worry about if the stock remains stable or rises. But in a falling stock market, this strategy can cause a lot of misery. When a market really heads south, only then does the real exposure become clear. So, stick to your size, especially if you write puts. Do not look at the margin, look at the underlying exposure.
In short, options offer sufficient opportunities to consolidate a profit. But before you apply any of the above strategies, make sure you understand them completely.