Using Options to Lock In Stock Market Profits – Part 3

In the last two options articles we discussed two different ways to preserve most of the profits from the current bull market, while retaining some upside potential. Those alternatives were:

• Keep the stock and buy puts as insurance

• Sell the stock and use a fraction of the money realized for buying call options

Each of these alternatives will result in further profits if the stock market keeps rising, but will limit losses when (not if) the market crashes.

Today we’ll look at the Put Backspread, another alternative that you might want to consider if you were not just apprehensive about the market, but downright bearish. It too has limited risk, no matter how high or low the market goes. The difference is that this one makes only a tiny amount of money if the market continues up. Where it makes its real money (if at all) is in the case of a full-blown crash. In that case, profits are larger the farther the market falls.

You might consider this strategy either in addition to, or instead of, the ones described in the earlier articles.

The Put Backspread has various uses, and one of those is to take on a low-risk bearish bet, as we will illustrate here.

Say that an investor has a stock portfolio that he or she bought five years ago, and it has performed on par with the market averages during that period. If the portfolio started out at $100,000 in 2012, today it would be worth about $191,300, for a 91% five-year increase. It would also have paid about another $9,000 in dividends for a grand total return of just about 100%.

Now, however, the investor believes, based on whatever tea leaves he’s been reading, that the end of this eight-and-a-half-year bull market is imminent. Not only that, he believes that it will end with a bang, as almost every other bull market in history has done. He wants to unload and position himself for the bear market.

The Put Backspread is one low-risk way that could be done.

1. Sell the stock portfolio and pocket the 100% gain. (Unless this was in an IRA or other tax-deferred vehicle which would have immediate tax consequences.)

2. Find a future option expiration date that is a bit over a year away. Let’s say January 2019.

3. Sell a put on a stock market index ETF, like SPY, with that January 2019 expiration date, at a strike price about equal to the current price of that ETF. As of today, the SPY Jan 2019 265 put could be sold for about $1583 per contract.

4. Find a put at that same expiration date whose price is a little less than half that of the put sold above – in this example, as close as we can get to $791.50 without going over. At this time that would be the 235-strike put, at $759 per contract. Buy two of those puts.

5. The two 235 puts together cost 2 X $759 = $1518. Subtracting that from the $1583 realized from selling the 265 puts leaves a net credit (money in) of $65.

6. The amount of money required as margin for each 3-put set would be 100 times the difference between the strikes, minus the net credit received. Here that would be (100 X ($265-$235)) – $65, or $2,935.

The profit and loss picture of this trade is as shown here:

The plan would be to exit in about six months (5/31/18) if no other triggers had occurred. Those other triggers are discussed below.

If no action was taken after putting on the trade, and it was held all the way until the 6-month deadline, here are the possible outcomes:

1. The market stays flat or goes up even more. In that case the puts will all be worthless. The original $65 credit will be the net profit on the trade. It would be closed out and new alternatives considered.

2. Worst case – the market slowly grinds lower, stalling around 8% lower in six months, at around $245. In that case (assuming no significant change in implied volatility) the trade could be closed out for a net loss of about $445.

3. If in 6 months implied volatility were to go higher than it is now, this maximum loss would be smaller. In fact, if implied volatility went up by six percentage points to around 17%, a SPY price of $245 would still be the worst case; but it would then be a break-even trade at worst – there would be no price of SPY at which the trade could lose. Again, that’s if SPY’s implied volatility increased. It could very well do so if the price dropped by 8%, especially if that happened suddenly.

4. “Best” case for this trade would be an all-out bloodbath for the stock market, since downside profit is unlimited. The trade would be considered in bloodbath mode at any time that its accumulated profit exceeded about 20% of the margin required, or about $600 per 3-put set. This could only happen in the case of a violent drop. In that case, the best way to manage the trade would be to place a stop-loss order to exit the trade at a limit price that would “give back” some fraction of its accumulated profit, say one third. This stop would then be adjusted at least once a week, or any time there was another sudden lurch to the downside (big increase in accumulated profit).

5. If and when, within the next 6 months, SPY dropped to the point (around a SPY price of 180) that all options came to parity (perfect -1 Delta and no time value left), then there would no longer be a time limit. The position could then be held until the January expiration of the options, the triggering of the 1/3 trailing stop or hell freezing over, whichever came first.

As you can see, the Put Backspread is not a set-and-forget trade. But if you expect a major crash and would like a low-risk way to profit from it, then it could be for you.

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