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.

618


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5 Responses to Use Options to Protect Assets and Feel Secure

  1. rick f. 02/19/2010 at 7:00 AM #

    I am in a similar situation managing my father’s decently-sized retirement portfolio, and was looking to do the same thing as the original poster.
    A word of caution: If the account is at a full service brokerage, be prepared for a prolonged and frustrating process getting options enabled (or enabled correctly) on your father’s account.
    It took multiple phone calls, faxes, and emails to enable options trading and then to ensure the correct trading permissions ultimately were granted! I ended up having to buy puts for protection because they dragged their administrative processes so slowly. Not a huge deal, and the timing was perfect anyway, but it was annoying in comparison to how my own personal and trading portfolios were established at online firms.
    I’m curious how others here have fared in the process of enabling options trading at full-service brokers. On my personal online trading account, no problem. Well-funded, with full authorizations. A few forms, clicks, and I’m fine. Trade whatever I want, up to and including naked calls
    It seems to me that full service brokers are less than enthusiastic about retail folks using options through them. Is that anyone else’s sense as well?
    At some point as I continue consolidating my father’s accounts, I will move them to an electronic broker just for simplicity’s sake, if not also cost ($50+ for a stock trade?) and features.
    Then again, online brokerages need to be cost-efficient and automated because they don’t have legions of “financial advisors” on staff that need to be paid. Frankly I wonder how any of these big guys still survive the retail market.

  2. Mark Wolfinger 02/19/2010 at 8:05 AM #

    I had no idea it was as bad as that.

  3. rick f. 02/19/2010 at 8:40 AM #

    Oh yeah .. FSBs are an odd bunch.
    For my father’s $400K account I faxed the forms up requesting ‘full option’ permissions. That means everything.
    They first approved me ONLY for covered calls. I couldn’t even buy a put!
    (Phone, fax, signatures, fax, email, phone)
    Approval for everything. Or so I thought. I look @ the fine print and it didn’t include naked calls. No SPX collar for me.
    (Phone, fax, signatures, fax, email, phone)
    Full permissions granted. Of course, i already had purchased the puts, and thankfully, had timed it right.
    … in another case at my own fullservice broker (one of the two Swiss ones) compliance department said I could not trade options on a $250K account unless I changed my “account purpose” from “conservative growth” to “speculation.” When asked why, the compliance folks said “options are speculative.” What’s so speculative about protecting your positions?[1]
    (After that, I plan to close the acct when the broker, a family friend, retires)
    [1] I only requested approval to do covered calls, long/short puts, and spreads. No naked calls or naked index calls.

  4. Mark Wolfinger 02/19/2010 at 8:45 AM #

    If he is truly an old family friend, he will understand if you pull the account now.
    If he doesn’t understand, he’s not as much of a friend as you make him out to be.

  5. rick f. 02/19/2010 at 12:43 PM #

    That’s very true. However, the account is well-positioned for the forseeable future so I’m in no rush to move it. But yes, I will have no problem when either he retires or before I do my next round of portfolio management.