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A Simplified Method for Buying Portfolio Insurance

I've recommended the idea of owning extra puts and calls as insurance against a major stock market move.  This insurance is only needed by traders who own positions with negative gamma, and who could otherwise be hurt by a big move.

There's no need to repeat the rationale behind this idea.  But if you discovered for yourself (or wish you had) how important this strategy is when the market either undergoes extreme volatility, or a steady, unidirectional move, then here's a simplified strategy you can use.

The trade begins with the sale of credit spreads.  These can be calls, put, or both (iron condor).  You can enter the order all at one time (recommended) or as two separate orders.

[I've been out of town for a week, and wrote several posts ahead of time.  Thus, I am making no attempt to use real prices because I have no idea where the market is today.]

1) Sell 3 credit spreads, for example RUT Sep 620/630.  Assume you collect $1.80 per spread, or $540.

2) Buy a naked call with a lower strike price.  Specifically, 3 strike prices lower than the call sold.  In this example, that's RUT Sep 600 call.  The cost is significantly higher than the $540 collected.  That means this is a debit spread and it costs money to own this position.  Although debits are not wonderful for premium sellers, it is part of the cost of doing business.  Insurance is not free.

This is a bullish play.  If the market declines, you will eventually lose the premium paid for the position (unless you accept the risk that comes with and selling your long call at some point).

If the market rises, you can never lose more than you invested (just as when you buy a call option outright).  You have two decent opportunities for profit (see below).

3) Optional:  Do the same type of play with puts, if you need downside insurance or want to make a bearish play.

4) Although I recommend not holding positions through expiration, it's much easier to talk about the result of this play by making the assumption that this is held all the way.  Obviously it's a good idea to exit the trade any time that you are satisfied with the profit or no longer need upside insurance.

a) IF RUT is between 600 and 620 at expiration,  the 600 call has value and you have a gain or loss, depending on how that value compares with the position cost.  Maximum credit you can collect (at this price level) for the position is $2,000. [At 620, the Sep 600 call is 20 points in the money and has an intrinsic value of $2,000]

b) Between 620 and 630, you begin to give back some of the profit at the rate of  $200 per point.  Why?  You are long one call and short 3 calls.  Being net short 2 calls, you lose $200 per point. [Because it is expiration, your long calls don't provide any help unless they become in the money]

c) At 630, your long call is 30 points in the money and is worth $3,000.  Your 3 short call spreads have reached their maximum value, and are also worth $3,000.  Your net loss is the cash you paid for the position, just as if all options expired worthless.

This is the reason behind buying the Sep 600 call.  You want the position to start accumulating value above the strike price of your long option.  If you don't use 10-point spreads, or if you chose a ratio other than 1 x 3, buy the appropriate call, instead of Sep 600.

d) Above 630, you earn $100 per point (as you would expect to do with any call option), with no upper limit.

NOTE:  If the long call is significantly in the money, it is going to be profitable to exit prior to expiration.  Why?  Two reasons:

1) Your long call still carries some time premium

2) The short spread has not yet reached it's maximum value of 10.

*** If you decide to exit the trade, don't pay $9.90 or $9.80 for the 10-point spread,  If you hold, you have a chance for a nice surprise, if the market tumbles and the spread declines in price.  Of course, there's a limit to how much to sacrifice.  For me, that 20 cents is about it.  For you?  Remember, not closing is gambling with some of your profit.

This is not perfect protection.  There are areas at which you have no benefit.  In exchange for that, you get to buy a well-struck (has a good strike price) call at a good price.

This is just another way to accumulate insurance.

ADDENDUM:  Later, I'll begin to describe this trade as a 'Kite Spread.'

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