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Use Options to Protect Assets and Feel Secure

Mark,

Just read your article on selling calls, thanks. My step-father is a bit uneasy in the market now and has 1.5 million in assets. 60% in equities via mutual funds/ETF's/some individual stock.

Here are my thought and if you could expand or correct me I would appreciate it:

Would he buy puts on an S&P index/Dow Index? Would you try to find that beta of the portfolio to see if this is the way to go, or do you need to find out what stocks are making up most of the portfolio. I think he would sleep much better at night knowing he had some protection, but I need to find out how much the insurance (puts) is going to cost. He is 70 yrs old.

Would you suggest selling calls on an index/certain stocks?

From what I gather this is solid theory too, unless the market loses a lot of value and the premium doesn't outweigh the loss in stock value.

Thanks,

TC

***

These are important questions.  And your general idea of how to handle the situation is good.

About your step-father. If he is UNEASY, then something must be done. Obviously you are looking for a good solution, but be certain that he is comfortable with any decision being made. Don't do something just to do something. Emotional comfort is very important.

1) If he were to buy puts, it's very unlikely that the DOW index would be the best puts. Obviously it depends on his holdings, but the S&P 500 Index (SPX) puts are more likely to be a better match; i.e., SPX is more likely to have a higher correlation with the market value of his holdings.

2) That said, I HATE (dislike, loathe etc) the idea of buying puts. That's my personal feeling and buying puts may be ok for some investors. The bottom line is that puts are expensive. And if you wait until the market is declining to buy those puts, they become even more expensive. There are better alternatives.

3) Portfolio beta doesn't tell you much that would be helpful with this decision. In his situation (not that 70 is old these days), his beta should not be 1.5 – that would be a very volatile portfolio. Beta near 1.0 is better suited for him, but beta values are difficult to find.   A 1.0 beta means his portfolio can be expected to perform in line with the major market averages. Neither much better nor much worse. 

4) I prefer selling covered calls to buying puts.  I prefer to collect that time premium rather than pay for it by buying puts. However, the biggest problem with this strategy is that downside protection is limited. It's minor protection. Covered call writing has been shown to slightly outperform a simple buy and hold plan.  I don't believe this is your major concern.  His discomfort is obviously fear or loss, not fear of making less on a large rally.

Thus, if downside risk is your major concern, the protection is limited to the cash collected when writing (selling) the options. 

5) To me, the right solution for you (please understand that I cannot possibly know enough of the details to make a specific recommendation for your situation, but this certainly feels right and I know I would do this if I were in a similar place) is to adopt BOTH of your ideas.

6) That means collars. Buy puts and sell calls. There are difficulties in making the trades – choosing which specific options to trade and how many to trade – and I cannot go into all the details in this post.  But if you get ready to act, post a comment/question and we can get into more details at that time.

If you trade SPX options, the broker is going to consider the call sales to be naked – even though you have bullish assets to back them up. That means a significant margin requirement. He may have enough funds to meet that requirement, but margin may present a problem.

If you buy and sell options on the specific items you own – such as he individual ETFs and stocks, then you will be making a bunch of trades and commissions become a factor. Your step-father may have been using the same broker for many years, but when trading options, you want to switch to a broker that charges minimal fees for option trades.

I've written about collars many times in this blog. Take a look at the categories in the right hand column and you can find those posts.

7) Don't rush into this. Be certain you understand what can be gained and lost with collars. This strategy protects the downside. The cost is sacrificing the big upside, if there is a strong rally. My guess is that both of you prefer that protection and that substantial gains is not your prime consideration.

What happened to my objection to paying for those puts?  When you sell the calls, most of the time the call premium is enough to offset the price paid for the puts.  Many times there is even a net cash credit.  That gives you protection at essentially zero cash cost.  The true cost is the limited upside.  A very good deal for both of you.

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