Just read your article on selling calls, thanks. My step-father is a bit uneasy in the market now and has 1.5 million in assets. 60% in equities via mutual funds/etf's/some individual stock.
Here are my thought and if you could expand or correct me I would appreciate it:
Would he buy puts on an S&P index/Dow Index? Would you try to find that beta of the portfolio to see if this is the way to go, or do you need to find out what stocks are making up most of the portfolio. I think he would sleep much better at night knowing he had some protection, but I need to find out how much the insurance(puts) are going to cost him. He is 70 yrs old.
Would you suggest selling calls on an index/certain stocks?
From what I gather this is solid theory too, unless the market loses a lot of value and the premium doesn't outweigh the loss in stock value.
These are important questions.
About your step-father. If he is UNEASY, then something must be done. Obviously you are looking for a good solution, but be certain that he is comfortable with any decision being made. Don't do something just to do something. Emotional comfort is very important.
1) If he were to buy puts, it's very unlikely that the DOW index would be the best puts. Obviously it depends on his holdings, but the S&P 500 Index (SPX) puts are more likely to be a better match.
2) That said, I HATE (dislike, loathe etc) the idea of buying puts. That's my personal feeling and buying puts may be ok for some investors. The bottom line is that puts are expensive. And if you wait until the market is declining to buy those puts, they become even more expensive. There are better alternatives.
3) Portfolio beta doesn't tell you much that would be helpful with this decision. In his situation (not that 70 is old these days), his beta should not be 1.5 - that would be a very volatile portfolio. Beta near 1.0 means his portfolio can be expected to perform in line with the major market averages. Neither much better nor much worse.
4) I prefer selling calls. I prefer to collect that time premium rather than pay for it by buying puts. However, the biggest problem with this strategy is that downside protection is limited. It's minor protection. This investment method has been shown to slightly outperform a simple buy and hold plan.
But if downside risk is your major concern, the protection is limited to the cash collected when writing (selling) the options.
5) To me, the right solution for you (please understand that I cannot possibly know enough of the details to make a specific recommendation for your situation, but this certainly feels right and I know I would do this if I were in your step-dads place) is to adopt BOTH of your ideas.
6) That means collars. Buy puts and sell calls. There are difficulties in making the trades and deciding just what should be done, and I cannot go into all the details in this bivio column.
If you trade SPX options, the broker is going to consider the call sales to be naked - even though you have bullish assets to back them up. That means a significant margin requirement. He may have enough funds to meet that requirement, but margin may present a problem.
If you buy and sell options on the specific items you own - such as he individual ETFs and stocks, then you will be making a bunch of trades and commissions become factor. Your step-father may have been using the same broker for many yeas, but if trading options, you want to switch to one that charges minimal fees for option trades.
I've written about collars many times in my blog. Take a look at the categories in the right hand column and read some of those blog posts.
7) Don't rush into this. Be certain you understand what can be gained and lost with collars. But this strategy protects the downside. The cost is sacrificing the big upside, if there is a strong rally. My guess is that both of you prefer that protection and that substantial gains is not your prime consideration.
8) If you need more details after giving this idea the effort required to know what you are doing - especially on choosing which options to trade - let me know.
Mark D Wolfinger
Partner and Director of Public Relations
Expiring Monthly: The Option Traders Journal