Sometimes when stocks get really exuberant – like tech shares have done lately – you can find yourself wondering whether their rally might be going just a touch too far. And when that’s the case, it can be handy to have a few options strategies in your pocket, ones that aim to shield your hard-earned gains, while still allowing you to take advantage if there’s more upside ahead. Here’s a trio of those strategies.

First, why bother with these strategies?

Sure, if you've got a truly long-term investment horizon, manage your portfolio entirely passively, or have the steely nerves to navigate losses and volatility without doing anything stupid, then maybe you don't need to change a thing. But there are a few scenarios where it makes a lot of sense to add a safety net for your downside. For example:

• You're getting cold feet about the rally and want to safeguard some of those sweet gains.
• You’re looking at returns on a risk-adjusted basis, and want to improve them.
• You've got a hunch the market is about to take a nosedive and want to tactically profit from it.
• You're looking to set a ceiling on your portfolio's maximum loss for risk management purposes.

And if that’s the case, here's some good news: the cost of protecting your portfolio against a market fall is quite attractive at the moment. In fact, Goldman Sachs has a model that compares the current risk of a correction, with the price of protection.

Goldman Sachs’s model shows that buying downside protection is attractive. Source: Goldman Sachs.

And right now, it’s saying that buying protection is extremely attractive. That’s not just because volatility – which can be thought of as the “cost of protection” has collapsed to new lows, but also because the model indicates that there’s a higher-than-usual chance of a pullback. So here are three ways to go about it:

Option 1: “Put spread”

If you buy a put option, you’ve got the option – but not the obligation – to sell the underlying asset at a pre-specified price (the “strike price”). That means that if it falls below the strike price, you can sell the asset at the higher agreed-upon price and pocket the difference. If the price climbs above, you simply don’t exercise the option. Here’s an illustration of how it works:

A typical payoff profile of buying a put option. Source: The Options Bro.

But since there’s no free lunch in finance, that option comes at a cost. And in practice, the price can be pretty hefty, which is why most big-league investors don’t solely rely on buying put options to shield their portfolios. Instead, they might opt for a different flavor: buy a put, but shave off some of its cost by selling another put with a lower strike price (think more “out-of-the-money”, meaning it's further away from the current price and therefore less likely to be cashed in. This “put spread” strategy still nets you a win if prices fall, but you cut your cost by capping your gains if a more serious correction happens.

Let's crunch some numbers with an actual example, using the Nasdaq ETF QQQ. Let’s say you want to buy a put spread expiring on August 18th and consisting of buying a put with a strike price of $330 (roughly 5% below the current price of $350) and selling a put with a strike price of $280 (about 20% below the current price). That put spread goes for $5.30, but since an option represents 100 shares of the underlying asset, you’ll have to fork out $530.

Payoff profile of the put-spread hedge. Source: Interactive Brokers.

At expiration (solid line), you’ll make money on the hedge as long as prices are below $325 (that’s the “breakeven” price and is equal to the strike price of $330, minus the $5 cost of the option). Before expiration (the dotted line shows the payoffs as of June 1st), however, you can make money, even if prices fall by less than 5%. That’s because a price fall – or higher volatility – increases the chance that the option structure will be exercised at a profit, meaning you can sell at a higher price.

As you can see in the chart, your downside is limited: whether prices rise by 30% or 5%, your loss is limited to the premium you paid for the option (at expiration – note that it will be slightly different before expiration). And while your upside is limited too – it reaches its maximum value of $4,480 when prices are down 20% or more at expiration – it’s 8.6 times bigger than your downside, giving you an attractive risk-return asymmetry.

All the above was simply referring to the hedge part. When you combine this structure with a long exposure in the underlying asset (in this case 100 shares in the QQQ ETF), you can see that you can significantly reduce your downside, while giving up only a minor part of the upside. So it’s a good strategy if you fear that a short-term correction is likely, but want to keep exposure to the upside.

The payoff profile of 100 shares in the Nasdaq ETF hedged with a put-spread. Source: Interactive Brokers.

Option 2: Put-spread collar

There’s a way to reduce your cost of protection even further, potentially even making your downside hedge completely free at inception: you can sell a call to finance the put spread. A call gives the buyer the option – but not the obligation – to buy at a previously agreed price, and so is used to bet on prices rising, rather than falling. By selling a call, you’re selling that option to someone else, meaning you’ll have to fork out the difference if prices rise above the strike. Put differently, you’re betting that prices won’t rise by too much. And since you’re the one selling the option, you’re also the one earning the option premium.

This put-spread collar strategy is not just cheaper to implement, but also, according to numbers crunched by Goldman Sachs, historically has resulted in higher risk-adjusted returns than the put-spread strategy. It would also have cut your maximum losses by more. That’s because you’re not only protecting your downside, but also earning extra income by selling call options that tend to be overpriced, and rarely exercised.

Let’s see how it works out in our real-life example. Since the put spread costs $5.30 per share, it implies (by looking for the option selling at this price) that you need to sell a call option with a strike price of $368 to make the structure cost-free at inception. Compared to a simple put-spread, the cost saving adds an extra buffer in case prices fall. However, your hedge is exposed to deeper losses if prices rise. In fact, the losses on your hedge (that is, ignoring the long position in the Nasdaq for now) are in theory infinite and so you should only implement this strategy if you own the underlying asset. Of course, you could also buy another call at a higher strike price to limit your maximum loss.

Payoff profile of the put-spread collar hedge. Source: Interactive Brokers.

When you consider the payoff of both the hedge and the underlying asset, you can see that you’ve got better protection on the downside than you’d have with the put spread (you’d experience a loss of $5,500 instead of $6,000), but you also have less upside, with your gains capped after a rise of about 10% (until August 18th). If the prospect of saving $500 to potentially give up a much larger upside seems like a terrible idea, remember that it’s all about probabilities, and a gain of more than 10% by mid-August isn’t terribly likely. Of course, you could also buy a call with a higher strike price, and so participate in more upside – although at a small upfront cost. If you think the rally is mostly over and want to protect your gains, this strategy could be the ticket.

The payoff profile of 100 shares in the Nasdaq ETF hedged with a put-spread collar. Source: Interactive Brokers.

Option 3: A 1x2

As I explained in more detail here, there’s a way to protect yourself from extreme selloffs while keeping all of the upside at the same time. And it can be done for free. The strategy works as follows: you sell a slightly out-of-the-money put option, and use the proceeds to buy two lower-striked puts (they’re less likely to be exercised and hence: cheaper). Of course, no cost at inception doesn’t mean that you can’t lose: if markets fall between the strike price of your two options, you can experience a loss on the hedge. But your loss is limited, and your upside materially bigger, if prices collapse. Still, the fact that the hedge can increase losses on your portfolio in the event of a small pullback means you should consider this strategy only if you're really concerned about a large selloff.

Back to our Nasdaq example. Selling an August put with a strike price of $350 allows you to buy two puts with a strike of $330, meaning it doesn’t cost anything to implement. Your maximum loss on the hedge is capped at $2,000 at expiration, but will be much lower before expiration as you can see with the dotted line.

The payoff profile of a 1x2. Sources: Finimize, Interactive Brokers.

Unlike the first two strategies, this one, when added to your long Nasdaq exposure, would cap your loss at just $4,000, while letting you keep all your upside. That being said, you experience a larger loss in the event of a small correction (which is not an unlikely scenario). So consider this strategy if you’re worried about a big selloff, but not if you expect a simple pullback.

The payoff profile of 100 shares in the Nasdaq ETF hedged with a 1x2. Sources: Finimize, Interactive Brokers.

So which one’s for you?

If you want to protect your downside at a small cost, the put spread is probably your best bet. If you’re willing to give up some upside in order to get a free – and slightly improved – downside protection, the put-spread collar might be for you. If you think a really big crash is unavoidable – and can handle a larger loss in case markets pull back only slightly – then consider the 1x2.

Payoff profiles of the different strategies at expiration. Sources: Finimize, Interactive Brokers

Payoff profiles of the different strategies at expiration and the long Nasdaq. Sources: Finimize and Interactive Brokers.