has jumped about 10% since it closed at 800 on March 11, and a lot of people are wondering if it might be prudent to lock in some profits. But while investors might hesitate to part with any shares to avoid any scary dips, they truly fear the possibility of missing further gains.
After suffering through three years of declines, who can blame them?
To deal with this sitution, one approach would be to purchase some insurance by buying protective puts. But they're expensive. For example, with the S&P trading at 880 at midday on Tuesday, the at-the-money May 880 put costs around $27. That price tag equates to a 3% move in the index, making you break even at 853. Your protection doesn't kick in until that price level.
Of course, the put could be sold for a profit prior to expiration if the index declines, but with little over a month remaining, the option's price will become increasingly comprised of its intrinsic value as it moves further into the money.
Even if the S&P hits 860 two weeks from now, giving it an intrinsic value of $20, the put will actually be priced a dollar or two less than the $27 you paid. This leads many people to complain that puts just don't work, which unfortunately can be true unless there is some catastrophic event.
What's worse is that if the market drifts sideways or goes higher, you'll lose all that premium. Based on the price we're using, the index would have to rise more than 3% in the next five weeks for you to recover the cost of a fully hedged long position.
Measuring the Odds
The numbers improve if you buy a longer-dated option, but would still represent a serious drag on returns. For example, the September 875 put currently costs about $66. That's a 7.5% move over six months, equating to 15% on an annualized basis.
What we need to do is find a way to defer some of the cost. So the next obvious idea is to use a spread in which you buy a higher strike put and sell a lower strike, with both having the same expiration.
For argument's sake, let's say I'm willing to assume some marginal risk if I could defer the entire cost. To do this, I will need to establish a ratio spread that involves selling a slightly higher number of the lower-strike (and lower-priced) puts.
Keep in mind that this will not only limit our downside protection, but also potentially expose us to more losses should the market collapse. The key is to keep the ratio as small as possible and use strikes that provide protection down to a reasonable level, or one at which you would feel comfortable buying more stock.
Take another look at the S&P (trading at 880) index options. I could buy the May 850 puts for $17 each and sell the May 825 puts for $11 each.
The table below shows the cost, maximum profit and the break-even level of a 2-by-3 spread. That means buying two 850s and selling three 825s.
I've chosen these strikes because the break-even point coincides with the October lows in the market. That's a level I don't think we'll revisit in the next five weeks. But be aware that as the index trades below the break-even of 775, losses start to mount. The table shows the potential loss if the index hits 750. If you aren't comfortable buying at that level, this approach might not be appropriate for you. Again, this isn't a position for protection against a catastrophic meltdown. Rather, it's a way to get some protection from a moderate market swoon.
What's nice about this strategy, as opposed to the outright purchase of puts or even a straight-up spread, is that if the market moves sideways or higher, it essentially costs you very little.
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 invites you to send your feedback to