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Keep Your Options Close, Your Hedge Closer

NEW YORK (TheStreet) -- When the market was drifting higher, finally punching through all-time highs, it seemed like everyone and their brother was calling for the almighty crash.

The "triple top" was in play for a while. But what investors didn't seem to understand was that the previous two tops where from epic market collapses in 2002 and 2008. Granted, there are certainly many macro concerns to worry about now, but nothing like what we went through a few years ago.

With the S&P 500 up 15% so far this year and the inevitable pullback coming, where do you stash your cash? Contrary to belief, cash is not king. Not in this environment anyway. If you haven't been in stocks, you haven't been making money.


But where do you go from here? If not cash, then where? Obviously U.S. equities have become the best alternative for many investors, hence the large increase in liquidity and huge yearly gains. When you look at bonds, I believe that's not the place to be. Treasuries can't even keep pace with inflation.

Now is when you look to your hedge to help you out. While using options can substantially enhance your gains, they can also protect them. Two basic strategies would include using collars, where you sell upward calls to offset the cost of purchasing protective puts; and buying index puts.

Let's look at the collar strategy first. For an example, we'll use Visa (V), which is up 17.5% year to date. Currently at about $178, we could sell the May 180 calls for $1.30 and buy the May 175 puts for $1.15.

This would actually result in a 15-cent credit, while still protecting your position and allowing you to participate in upward price action, (to $180; $180.15 if you include the 15-cent credit). It essentially acts as a trailing stop. If Visa pulls back and closes below $175 by May expiration, you'll be protected.

Basically, if you were to replicate this strategy, your three options (no pun intended) would be:

  1. Visa is between $175 and $180 and you keep your stock and the 15-cent credit per share; $15 total.
  2. Visa is over $180 and your 100 shares get called away, and you keep the 15-cent credit.
  3. Visa is below $175 and you have the right to sell your 100 shares at $175, and still keep the 15-cent credit. You could also keep the shares at the current price and sell the put for a gain.
Obviously the tradeoff of having protection at $175, is having our gains capped at $180. But assuming we bought Visa on the first trading day of 2013, for simplicity, we would be holding a gain of approximately $20 per share, if we got punched out at $175. Your max loss (even if you choose to hold on to the stock and just sell the put in the open market) would still net you gains of nearly 13%.

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