Speculation Blues

Using Options for Downside Protection and Additional Income

Speculation Blues

Question: If I am concerned about a potential drop in the market, should I buy a put option to protect myself? Also, would it make sense to fund the cost of the put option by selling a call option?

Answer: A put option allows you to sell shares at a pre-set price (the strike price). If you own shares and they fall below the strike price, you have essentially limited your loss to difference between the original price and the strike price plus the cost of the put option. Of course, you could also have essentially accomplished this with a stop-loss order which costs nothing (aside from the possibility that your actual selling price may be lower than your stop-loss price, if the market makes a large move in a short period of time).

The pricing of options is highly complex and well beyond the abilities of 99% of retail investors (ourselves included). The institutional investors that trade options (such as Goldman Sachs) run highly sophisticated models that are overseen by guys like Nobel Laureate Harry Markowitz (as he recounted to us a few years ago). If one of them is on the other side of your trade, you can be absolutely certain that you are the proverbial sucker at the poker table.

This is also why we advise against selling call options (which allow the buyer to buy your shares at the pre-set strike price) whether to generate additional income or to fund the purchase of a put option. Selling a call by itself limits your upside and does nothing to protect your downside. The only index fund that we know of that incorporates the strategy of selling call options is PBP (PowerShares S&P 500 Buy-Write Fund), and for the five years ending 10/31/2013, it has lagged the S&P 500 Index by 7.8% per year on average.

For most investors, a better approach to mitigate the risk of their equity assets is to combine them with low-risk fixed income investments. To determine the percentage of their portfolio that should be in risky assets, IFA’s Risk Capacity Survey is recommended.

One final consideration is that the taxes involved with option trading can be excessive, often involving short-term gains.