I have been teaching my son about the stock market, and how I manage the risk of trading in shares, bonds and options. The first rule I taught him was something I learned from the Oracle of Omaha. Rule 1: Never risk losing your money. I then went on to Rule2: If you are not sure what to do, refer to Rule 1.
However, as the Bear knows, there are times when the market will decline. If you are holding positions in stocks, this generally means that the value of your portfolio will decline also.
There are many books written about strategies to offset portfolio losses, or even profit from market declines. Most of them revolve around the use of Put Options, or short-selling stocks.
Short selling stocks is perhaps the most effective way to profit from declining markets. However, If your resources are limited, you should be looking at Options strategies.
For a long term risk management strategy, buying Put Options ticks most if not all of the boxes.
One of the un-ticked boxes is longevity. Options expire. If they expire unexercised, the money spent on their purchase is gone. This obviously contravenes Rule1.
While there are many uses for Put Options, for shorter term market declines (and by shorter term I mean less than 3 months) I prefer to sell Calls that are out of the money, with a 1 month expiry. There are several reasons for this.
The first is, if the market does not decline, time value, known as theta, works for you rather than against you. If the theta is positive, for every trading day you collect the theta dollar amount. In the month that the option expires, theta decay accelerates, and your liability to sell the stock at the call price decreases. An in-the-money Put decreases in value the closer you get to expiration, as the theta is negative.
The second reason is the delta.
Delta, in simple terms is the amount that a Call, Put or other financial instrument changes for every dollar that the underlying stock rises or falls. Thus, the delta of a share is 1 – if the share price rises $ 1.00 the value increases by a dollar. An in-the-money Call will have a delta of close to 100, as there are a 100 Call options in contract. An in-the-money Put will have a delta of close to -100.
So, if you sell an out-of-the money Call, the delta will be lower than if you buy an in-the-money Put to protect your portfolio.
If the market moves against you, that is, climbs rather than declines, you will lose less from a short Call than a long Put. If delta is positive, you gain the delta amount for every dollar increase in the share price, and lose the delta amount for every dollar of decrease in the share price. The reverse is true for negative delta – you lose the delta amount if the market rises, gain the delta amount if the market declines.
Third, the spread between the buy & sell for an out-of-the-money call is usually much less than the spread between the buy and sell of an in-the-money put. The spread is the difference between the “buy” and the “sell”. So, if you have to buy your option back, either because the market moves against you, or to avoid exercise at expiration, you will lose less from a short Call than a long Put.
When I am bearish, and believe the market will decline, I protect my long positions by selling Calls that have a short expiration, positive theta, and a low delta.
If you found the information useful, interesting, or just confusing, you can get more of the same by going to http://www.abfgroup.biz and looking for the options education link. Good luck in your trading.