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%.

There's also another hedging solution, one that is much more broad and simplistic: Buying index puts. If you don't own more than 100 shares in specific securities, or don't want to have them exercised out of your account (for instance, because of tax reasons) then you can look to the indices for protection. Broad portfolio insurance, while less specific to your portfolio, is also cheaper, since the commission rates will be lower and you won't need to replicate it for each stock.

By purchasing put options on the S&P 500 ETF ( SPY), for instance, we can protect against a broader market selloff. Again, for simplicity, let's say we are trying to protect a $50,000 portfolio that currently has a beta equal to 1. Let's use the SPY, again for simplicity.

Beta greater than 1 would mean more put options are needed and beta less than 1 means less put options are needed, with a beta of 1 being equal to the S&P 500. For example, if you had a beta of 2, you would need twice as many put options to offset the move in your portfolio, relative to the S&P 500. Conversely, if your portfolio had a beta of 0.5, you would need half as many puts.

Back to our example. For a $50,000 portfolio, we would need just over 3 SPY puts to insure the portfolios. This number is calculated by dividing our portfolio value by the value of the SPY. With the SPY ETF trading close to $163, this would equal 306.74, ($50,000 / $163 = 306.74). Think of this as 306 shares of the SPY.

Technically, we would need 3.06 puts, since each put option represents 100 shares. But since we cannot buy six-one-hundredths of a put, we'll just round down to three. Currently, the SPY at-the-money $163 June quarterly put costs $3.15. Multiply this by the three puts we need and we come up a total cost of $945, excluding fees.

Considering that indices continue to make all-time highs and that we've gone so far, so fast, it wouldn't make sense to be blind to a correction. However, you don't want to miss upside momentum and you certainly don't want to be stuck in cash or in bonds.

The common saying, "the trend is your friend," still holds true. The market has been all momentum and almost all to the upside. You don't want to fight the Fed or the tape, but with some insurance, you can be sure to stay in the game.

Our $945 hedge represents 1.8% of the portfolio, a rather cheap form of insurance (especially at all-time highs), indeed. Remember, the indices' insurance can be tailored to your portfolio's holdings. For example, the Nasdaq ETF ( QQQ) could be used for a more tech-heavy portfolio.

At the time of publication, the Kenwell was long V and long SPY puts, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Bret Kenwell currently writes, blogs and also contributes to Rocco Pendola's Weekly Options Newsletter. Focuses on short- to intermediate-term trading opportunities that can be exposed via options. He prefers to use debit trades on momentum setups and credit trades on support/resistance setups. He also focuses on building long-term wealth by searching for consistent, quality dividend paying companies and long-term growth companies. He considers himself the surfer, not the wave, in relation to the market and himself. He has no allegiance to either the bull side or the bear side.

More from Options

Market of the Week

Market of the Week

Novice Trade: American Airlines

Novice Trade: American Airlines

Should Traders Get Sirius on SIRI's Drop?

Should Traders Get Sirius on SIRI's Drop?

Market Movers: September Grain Stocks Report

Market Movers: September Grain Stocks Report

Novice Trade: Apple

Novice Trade: Apple