This article originally appeared on RealMoney on March 4.
No matter this latest intra-day rally, it's never a bad idea to review how to use options to stem losses during a declining market. I know I've written on this subject numerous times and discussed how there is no such thing as a perfect hedge, but with the market suffering, investors are now acting like people who don't go to the dentist until they are in real pain. And for many retail investors, volatility, not just a decline in price, equates to a very uncomfortable condition.
So far this year, the VIX, which measures the implied volatility of S&P 500 index options and is the de facto measure of perception of broad-market risk, had been trending higher. It hit a four-year high of 36 on Aug. 16, and despite its retreat of some 27% to around 25, it is still about 80% higher for the year to date.
This increase in implied volatility (IV) or risk premium is in large part simply a reflection of the reality that the real or historical volatility (HV) of the index and individual stocks has increased dramatically this year.
For a graphic comparison of HV and IV for the S&P 500 index, take a look at this page on
. As you can see, the IV has basically tracked the HV all year. But how does one deal with this increase in volatility?
Risk or Opportunity?
As I've discussed in past, the prudent way to approach trading, or even long-term investing, is to adhere to the mantra that "defense wins championships." That means that the first step in establishing a trade or building a position should be focused on the risk part of the equation rather than potential gains.
That is why I constantly hammer the concept of maintaining an inventory of puts in one of the broad-market indices, whether it be the
Russell 2000 iShares
, which are just two among a wide range of products available.
Options get a bad rap as a risky investment product because too many people focus on the leverage that can provide unlimited profit potential. The reality is that options were originally created as risk-management tools, or ways to buy insurance.
The other reality is one never realizes an unlimited profit -- that is nothing more than a siren song -- and one should have reasonable expectations for taking profits. That means entering each position with well-defined risk/reward parameters, which becomes especially important during periods of increased volatility.
One of the simplest and most straightforward ways for limiting risk is to use a married-put strategy: that is, the purchase of put options in combination with being long related stock or index products.
In a recent article
I used the
Financial Sector Select SPDR
as an example.
As it turned out, my suggestion of buying the full protection, or starting at delta neural and long gamma, was the right way approach. At the time, I did not know that the XLF would slide another 10%, but my gut feeling was that the turmoil was not over, and being long volatility, and starting with full protection was the prudent approach.
As a quick reminder, one at-the-money option has a delta of 0.50, meaning the value of the option will move 50 cents for every dollar move in the underlying stock. An options delta is defined by a slope, so the more the option moves into-the-money, the more the option will track the value of the underlying security. This works in reverse as the option moves further out-of-the money.
To see how delta and the other greeks work toward hedging your portfolio, you can look at this past article.
And remember, the only pure hedge against a decline in a stock's price is to is to simply sell the stock.
Steve Smith writes the Options Alerts newsletter for TheStreet.com. Each week Smith prepares a winning cocktail of options trades for his subscribers. He's currently got options plays on a variety of companies including ICE, Apple and Joy Global, as well as the Spyder Trust.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;
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