In our last option article, I talked about one way of protecting at least a large part of the value in a stock portfolio. With stocks at all-time highs and a market that stands over 240% above where it was at the low in 2009, many people are in a position to need some sort of protection.
Although we know that every bull market is inevitably followed by a bear market, no one can possibly know when that next bear market will start, or how bad it will get. So, with risk management in mind, we want to look at possibilities for taking some money off the table after this big run-up, without getting out of the game altogether.
For all of these different possibilities, we’re assuming that we have a stock portfolio of $250,000 worth of stock. This could be individual stocks, exchange-traded funds (and in some cases mutual funds).
The last article described what I termed Option 1 – keeping the stock holdings and buying puts as insurance. Today we’ll look at Option 2.
Sell Stock, Buy Calls
An obvious way of avoiding giving back any profits on a stock portfolio is to sell it. You can’t lose the game if you get out while you’re ahead. This would turn out to be a genius move if the Crash of 2017 started right after your order was filled. (You would, of course, have to deal with paying tax on the capital gains if your stock holdings were in a taxable account. Though this would not be an immediate issue if they were in an IRA or other qualified retirement account).
But, if the Crash of 2017 doesn’t start until 2020, then selling will seem not to have been so smart.
You could, of course, sell some and keep some, or you could consider this: Sell the stocks and bank the profits. Then, use a small portion of the cash proceeds, say 5%, to buy call options on the stock market that expire in a year. Purchasing call options is a leveraged play where the lever only works in one direction (the right one). If the stock market goes up substantially, then you will make a profit on the calls. That profit could be much more than the 5% they cost you. If the stock market does crash, then the calls will have no value. But, in that case you will have lost only the 5% of your stock portfolio value that you spent for them with the rest safe in the bank or treasury bills.
Notice above that I said if the stock market goes up substantially; and that I said that your profits could be more than the 5% you spent. There is no guarantee of either, and it is quite possible that the calls would become worthless. In that case you would end up down 5%, partly offset by whatever interest you made in a year on the cash. You would only consider this option if you were willing to live with that as the worst case (and if current capital gains taxes were not an issue, as in an IRA).
As of today (November 8, 2017), SPY stood at $259.11 per share. Options that expire on December 21, 2018 at the $260 strike price could be bought for $1400 per contract. Here is how the math would work out:
- Sell $250,000 worth of stock. Use about 95% of that amount, $237,400, to buy a 1-year CD (currently yielding about 1.75%). This CD will earn interest of about $4,155 over one year.
- Use the remaining $12,600 to buy 8 December 2018 SPY 260 calls at $1400 each.
- Check in in a year (11/8/2018). Here are some possible scenarios at that time:
- Worst case: the stock market has crashed by 50%, as it did in 2000 and again in 2008. You are glad you did not hold the stocks, since if you had you would have suffered a loss of $125,000. In our case the call options are worth nothing. But the $237,400 is still in the bank, now joined by $4,155 in interest, for a total value of $241,555. Your drop in net worth has been $8,445 overall. This is your worst case. You cannot actually lose more money than this $8,445 (unless your bank fails and the FDIC is broke).
- Neutral case: the stock market is flat in a year. The $241,555 is in the bank as above. The call options in this scenario would be worth about $3,060. Your total stock portfolio is now $247,615, still a drop of $2,385. Not wonderful, but then again you had no risk.
- Moderately good case: The stock market increases by an average amount, around 5%. Your call options would be worth about $10,278, which is less than the $12,600 you paid for them by $2,322. That small loss is more than offset by the $4,155 in interest. Your net worth has increased by $1,833, a net return of 0.7%.
- Pretty good case: The stock market goes up by 11%, as it did in 2010 and 2012. The calls would be worth about $22,160, for a profit on them of $9,560. Your net worth has increased by $13,715, a 5.5% return.
- Very good case: The stock market soars by 27% as it did in 2013. With SPY at $329, your calls would be worth about $55,300, a profit of $42,700. Including the interest, your total return is $46,855, or 18.7%.
As you can see, the option of selling stocks and buying calls has these features:
- There is no possibility of any significant loss, no matter how bad a drop the stock market has.
- The new stock portfolio will make a good return, but not as good as leaving the money in the stock market would have, assuming if the stock market does moderately well or better.
For many people, this will be an attractive alternative. For others – tune in next time.