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The Cost of Protection

Trying to save a few bucks might wipe you out.

This column was originally published on RealMoney on Oct. 12 at 11:50 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

The options column in this morning's

Wall Street Journal

posits that, with the VIX and the implied volatility on related index products near historic lows, it makes sense to use puts to gain some downside protection.

That makes a world of sense to me, as

I've noted that the cost of put insurance rarely gets cheaper than it is now. It's running at just about 9% on annualized basis if you use options with six months remaining until expiration.

So I don't understand why the options strategist from Credit Suisse who is quoted in the piece would recommend using a ratio spread in attempt to bring the cost down to zero. Specifically, he suggests using

S&P 500

index options to buy one December 1275 put and sell two December 1225 puts for even money.

The article does point out the profit/loss and breakeven points, based on where the SPX is at the Dec. 15 expiration: You'd start making money on a 6% decline, or at 1275, and the maximum would be achieved on a 10% decline, or 1225. Losses would be incurred if the index falls below the 1175 level, or about a 14% decline. What the article does not point out is that the losses are unlimited if the market keeps declining.

Of greater concern and confusion is the idea of recommending a ratio spread -- that is, selling more contracts than you own, which results in a "naked" position -- without addressing the impact that an increase in IV would have on such a position.

If the S&P 500 were to decline even 10% within the next month, it's safe to assume the IV on the December options would rise back above 20%. Remember, during the summer swoon, the VIX hit a high of 24% when the SPX bottomed at 1220 in mid-June.

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A quick look at this handy

options calculator shows me that if the S&P 500 were at 1215 one month from now and IV rose to 20%, the value of that 1x2 spread would be worth just $3.

This illustrates the two main problems with using a ratio put spread to gain downside portfolio protection. First, it is negatively impacted by an increase in implied volatility, something that usually accompanies the type of steep drop you're trying to protect against. Second, it's very difficult to take any profits before expiration.

If you want to use a spread to reduce the cost of buying downside protection, I'd suggest a straight one-for-one vertical spread. For example, one can buy the December 1300 put and sell the December 1250 put for a net debit of around $5 for the spread. The position has a maximum profit of $45, which is similar to the $50 maximum profit of the aforementioned ratio spread, but it only takes a 4.3% decline to start realizing a profit.

Also, the even number of contracts bought vs. sold will mitigate the impact of an increase in implied volatility, meaning one can take a profit if the spread moves into the money before expiration. Most important, the risk is limited to that $5 upfront cost, which equates to about a 3.5% expense for 10 weeks of protection.

Using a ratio spread might save you a few bucks in the near term, but if the very market decline you're trying to protect against becomes too much too fast, it could end up wiping you out. The last thing one wants to do in establishing portfolio protection is to be penny-wise and pound-foolish.

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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