Hedging gains after this run-up

Posted on April 1st, 2013

After a big run up in the market like the one we just had since the post-election lows, it is tempting to take some money off of the table. But it feels terrible to do that and then watch the market run up some more. Maybe we can accomplish both.
If you are hedged using our most popular technique (using collars), you probably already own a lot of OTM puts protecting your positions. In fact, given the run-up, those protection levels are probably at LEAST 20% out-of-the-money at this point if they are expiring in the next 1-4 months.
If you want to protect your gains here, you might want to consider hedges much closer to the money – but MUCH further out in expiration. If you have hedges set to expire as soon as 1 month from now or between now and June, consider rolling in to the January 2015 expiring puts if they exist for the ETF you like.
Let’s look at an example: The January 2015 expiration for the SPY for the $150 puts. These are only 2% out of the money based on todays $156 level in the SPY. These will cost about $13.80 – or about 5% on an annual basis.
Here is the plan: buy this protection to lock in MUCH closer protection levels than you normally would have. Plan to roll out of this protection around 9-12 months prior to expiration (ie, around 1 year from now). Continue to sell calls to help to pay for these puts – targeting around 3% in call premium per year.
The risk profile would look like this:
  • If the market corrects in the next 6-12 months, you will have protection that kicks in and starts to offset some of the losses immediately, instead of the deep OTM protection you own today.
  • If the market starts to go up, you will still enjoy the ride up in the markets – and the deep ITM puts will not cost you materially more than the 6-month puts you regularly purchase.
Why do this trade? You want protection close to the money – but you are worried the Bull market could really continue in earnest.
Why is this opportunity available in the market right now? Because volatility is very low – even close to historical lows.
Why do we like this trade? We like buying cheap protection – and we always will.

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