How To Protect Your Portfolio From A Crash – For Free

How To Protect Your Portfolio From A Crash – For Free
Stéphane Renevier, CFA

over 2 years ago4 mins

  • By selling one slightly out-of-the-money put option and buying twice the amount of deeper out-of-the-money put options, you’re benefiting from a crash at no cost.

  • Although you could still experience losses if prices experience a mild loss.

  • You could apply this strategy on the underlying stocks you own to get free protection against a crash, or use it directly to express a bearish view on any asset you think has significant downside potential but a higher chance of going higher.

By selling one slightly out-of-the-money put option and buying twice the amount of deeper out-of-the-money put options, you’re benefiting from a crash at no cost.

Although you could still experience losses if prices experience a mild loss.

You could apply this strategy on the underlying stocks you own to get free protection against a crash, or use it directly to express a bearish view on any asset you think has significant downside potential but a higher chance of going higher.

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So you think the market might crash, huh? Well, there’s one strategy that will protect your portfolio if you’re right, and it won’t cost you a dime to implement.

What is this strategy?

This little-known option structure – called a “1x2 put ratio” – works as follows: sell a slightly out-of-the-money put option, and buy twice the amount of deeper out-of-the-money put options.

Remember that the buyer of a put option stands to benefit when the underlying asset price drops below the strike price, and the seller experiences an equivalent loss (excluding the premium paid or received). So here’s how it works.

Say a stock is currently trading at $105. Let’s assume the price (or “premium”) of a put option with a $100 strike price is $3, and the price of a put option with a $95 strike price is $1.50. In the 1x2 ratio, you’d sell the more expensive put option and receive $3 for the privilege. You’d also buy two of the cheaper put options, and pay 2 x $1.50 = $3. So you’re not paying a cent to implement the trade, and you’d get a payoff profile that looks very much like a normal put option:

Payoff profile of 1x2 put ratio. Source: Finimize
Payoff profile of 1x2 put ratio. Source: Finimize

Put simply, if markets go up, you don’t lose anything. If markets crash significantly, you stand to make big gains.

Is there a catch?

Afraid so. You won’t lose anything if prices rise and maximize your profits in a significant crash, but you could experience a loss – albeit a small one – if the stock falls just a bit and ends up just below the options’ two strike prices.

The advantage next to a normal put option is that there’s no initial cost, which can be significant and could greatly reduce your returns over time. But the disadvantage is that you could experience a loss larger than the premium you pay. That would in turn push the break-even price – that is, the price at which you start making a profit – slightly further away.

That being said, your maximum loss is limited, and you’ll know it in advance: it’s equal to the difference between the two strike prices, so $5 in our example. That means you could size the trade based on the maximum amount you’d be willing to lose in that worst-case scenario. And the advantage of the 1x2 structure is that it tends to benefit from higher volatility, meaning you could bump up your returns even more if you implement it when volatility is low.

What else should you be aware of?

There are a few technicalities you need to be aware of. First, you have to decide which options to buy. It’s important you buy options with the same expiration date and the same underlying, as a mismatch could lead to some nasty surprises. Longer-term options are also arguably a better fit than short-term ones for this strategy: they require less frequent rebalancing, and their value tends to drop less over time.

Second, it’s important to rebalance the strategy if stock prices go up significantly, as you could end up in a situation where prices rise before crashing down below the original prices, leaving you with a loss. And third, there’s the risk that the buyer exercises the option you sold before expiration. In that case, you’d end up with a long position on the stock, and could face a margin call if you don’t have enough liquidity to buy. It’s important you plan in advance for this eventuality.

What’s the opportunity here?

If you own a lot of stocks in your portfolio, applying this options strategy to a broad index like the S&P500 could be a cost-efficient way of reducing losses if there’s a significant market crash.

The trade-off is clear: if prices fall below your breakeven price, the exponential gains you’ll make on the option strategy will offset losses in the rest of your portfolio. If, on the other hand, stocks rally further, you’ll keep benefiting and you’ll have acquired a hedge for free. Of course, if markets experience a small drop, the hedge could compound your losses.

There are a couple of other possibilities with this strategy. One is to tailor the payoff more closely to your objectives. You could, for example, buy put options slightly more out-of-the-money, or sell put options closer to the current price, and you’d essentially be paid to implement the strategy. You could also limit the maximum loss by selecting strike prices that are closer to each other.

Another is to implement the strategy on its own – not as a hedge, but as a way of betting against an asset you think has a high chance of rising further and a small chance of a big drop. Great candidates could be companies about to report earnings, assets like bonds that are driven by central bank announcements, or volatile assets like cryptocurrencies, as you’d profit from large unexpected negative news and preserve your capital if they come up as expected.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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