With Puts, You’ll Never Sweat Another Market Drop
I hate to say it, but I see a LOT of similarities between this market and 2008…
Back then, I was still in the military and learning about the markets. I deployed to Iraq.
Before leaving, though, I met Mike Carr.
Mike told me that my intelligence background could help me analyze markets. The more we talked, the more I realized he had a point.
So, when I deployed, I asked him to send me updates on the market so I could start learning how to trade.
If you’ve been reading Mike’s stuff a while, you know he’s prolific. He writes every day, including weekends and holidays. I’m certain I saw market analysis every day that I was deployed, including Christmas Day.
This made me realize that market analysis was like the military — you never really clock out.
A lot of what I teach in this Options Bootcamp series comes from what I learned from Mike during these pivotal years. And today, I’m sharing the most important lesson he taught me for times like these…
How to insure your portfolio against ugly price action.
The Most Important Consideration
One of the points Mike emphasized while I was deployed was that safety is the most important consideration.
At first, I thought that was his nice way of saying “be careful.” But I soon realized he was just highlighting the connection between the military and the markets.
There are many ways to build safety into trading. One of the simplest is buying put options.
Put options effectively allow you to sell stocks at whatever price you want. Each put option you own lets you sell 100 shares of a stock or ETF at the strike price you choose any time before it expires.
Let’s say you own a stock trading at $100. You could buy a $90 put option on that stock for $0.50. If the stock falls to $80, that put is worth at least $20.
If that happens, you can sell the put option and profit that way. Or you can exercise it, and sell the stock at the strike price if you hold 100 shares of it in your account.
(If you missed last week’s Options Bootcamp and need a refresher on how to pick an option for a trade, catch up here.)
That’s essentially an insurance policy on your position. If something goes wrong, you can use your insurance to recoup losses and sell the stock at a better price.
This is a critical technique to understand right now.
There’s a lot of risk in the current market. Stocks are overvalued and interest rates are rising. These two factors alone are enough to consider adding insurance to your portfolio.
But there’s more. There’s inflation, war in Ukraine, possible COVID variants, and a midterm election in six months. If the Fed tightens too quickly, we could see a recession. If the Fed doesn’t act fast enough, we could see a recession.
I could go on and on. The point is there are risks, and we need to know if we can offset them.
But the thing is, holding long-term put positions is NOT the best way to offset these risks and insure your portfolio.
Trade THIS, Not THAT
Put options, when used as insurance in the way I just described, are expensive.
Here’s an example…
The SPDR S&P 500 ETF (SPY) is trading near $460. There’s a $460 put expiring on December 30 that costs about $35. So, each contract protects $46,000 of my portfolio ($460 * 100 shares). Insurance costs $3,500, or 7.6% of the portfolio.
If the stock market moves higher and stays above $460 by December 30, that option will be worthless. If SPY gains 8% by the end of the year, my portfolio will increase just 0.4%.
But if SPY falls, I have protection. Let’s say it drops 20%. In that case, the option will be worth at least $92. That will offset much of the loss in my portfolio, but I’ll still have a loss of 7.6%, the price I paid to buy my insurance.
As we see, holding long-term puts as insurance is expensive, and not an attractive option for most traders.
So the real way to make money in a down-trending market is with short-term put options.
I buy puts when I expect declines, and quickly close the trade to deploy that capital in the next opportunity I find.
That’s the same approach Mike uses in One Trade. Using it, he’s collected gains of 77% and 61% on puts so far this year.
He’s also delivered 41%, 95%, and 142% gains on calls during market rebounds this year, since he focuses on the short term and holds positions for less than three days most of the time.
This is my preferred way to use puts. Rather than making one big bet that the market will fall, I like making lots of little bets that adapt to the market action.
This way, I benefit from the ups and downs of the market rather than waiting for that one big trend.
So, think of put options as less of a long-term insurance policy, and more like a trading tool to play the downside in the market when the trend is clearly pointing that way.
This is the smart way to use the leverage of options to your advantage, while limiting your risks at the same time.
Regards,Amber Hestla Senior Analyst, True Options Masters
Chart of the Day:The Trend Has Officially Changed
By Mike Merson, Managing Editor, True Options Masters
If you aren’t yet convinced of a comeback in crypto prices, take a look at this chart.
This is a Heikin-Ashi chart of Ethereum, the #2 cryptocurrency by market cap.
Heikin-Ashi is a type of candle that, instead of recording the highs and lows of a price on any given candle timeframe, records the average price. This smooths out the price action and, most importantly, gives you an idea of the trends at work in a market.
Reading them is simple. Green candles with long upper wicks and no lower wicks indicate an uptrend. The opposite is true for downtrends.
Trends change when we see candles with long upper AND lower wicks, followed by a candle that’s the opposite color.
We’re currently looking at our second weekly green candle on the Heikin-Ashi chart, which hasn’t happened since November. At the same time, the weekly moving averages are turning higher, and trying to cross above the longer-term moving average.
If you ask me, this is the start of a new uptrend in crypto that will take most of the blue-chips to new highs this year. And I’ll hold that view until we see the next trend-change candle print on the weekly.
Regards,Mike Merson Managing Editor, True Options Masters