Most investors have a long bias to their trading. They likely research fundamentals of a company, read analysts’ opinions, check on the technicals, and attempt to find quality companies in which to invest. Unfortunately for these bulls, a weak market will often punish this diligence in stock selection. Remember all stocks have an overall market component to them, and just as a rising tide raises all boats, sometimes in a falling market the “baby gets thrown out with the bathwater.”
“Hedge your bet”, market commentators have suggested. Sounds good in theory, right? However, the cost of buying a stock and subsequently buying puts to hedge against downside moves in the stock’s price can be prohibitively expensive. This strategy gets especially expensive when the market is nervous or in a downtrend, which may elevate implied volatilities and make those put options even more costly.
For the sophisticated investor, there may be a way to lower the cost (but not the risk) of a potential downside market hedge that actually takes advantage of elevated volatility. This may be accomplished, for example, through put ratio spreads and employing these spreads on a broad-market exchange-traded fund (ETF) such as the SPDR S&P 500 ETF (Spiders, or SPY).
The goal of this strategy is to offer a hedge against overall market risk on long stock positions for a lower cost. This is not a hedge of specific stock risk. The rationale behind this is that broad-market risk is typically priced lower than specific stock risk as measured by the implied volatilities of the options. Also of critical importance: the put ratio spread is not a good choice if the market has a cataclysmic drop lower as you will see in the example below.
The definition of a put ratio spread is the purchase of one put and the simultaneous sale of two lower-strike puts. Another way of looking at it is as a long debit put spread (a bear put spread), with an additional downside short put.
I have described the put vertical spread as a strategy that lowers the cost of a straight put purchase by limiting the potential reward and selling a downside put. This ratio spread sells another of those further-out-of-the-money puts, reducing the cost of the trade even further. The additional put sold changes this from a limited reward/limited risk trade to a limited reward/essentially unlimited risk trade. Nothing is free in options! However, let’s look at the profit/loss (P/L) charts for this trade and explore why the strategy might make sense.
In this example, I am looking at the SPY December 108/99 1×2 ratio put spread that is priced for a net debit of 15 cents (plus commissions) midday Thursday. From the very time the trade is placed, the (P/L) chart is not looking so sweet. Certainly it doesn’t seem to show much promise to the downside:
Over time, however, you can see how the limited downside hedge evolves. With 50 days to go until expiration, the delta is now negative, and the potential P/L expands to move lower in the market.
With 25 days to go until expiration, the P/L hump becomes even more pronounced:
Finally, at expiration the ultimate risk/reward is clear:
The downside breakeven is 90.15 in the SPYs. The maximum profit of $885 is realized at $99 in the market. And the trade is profitable between the breakevens of $107.85 and $90.15. If the market does not fall by December, the initial cost of 15 cents will be forfeited, but presumably the stocks you have selected have performed admirably.
The key here is picking the strikes to give a range of profitability you desire. Also you can select strikes that actually allow doing these ratio spreads for a credit, which would create a small profit even if the market doesn’t fall.
Again, nothing comes free in options trading. The cost of this spread was lowered by selling an additional put option. The risk to a sharp move below $90.15 is basically unlimited down to zero! Should the market move lower immediately after putting this trade on, the first P/L graph shows how this position will be marked against you.* However, over time, a 1×2 out-of-the-money put ratio spread can be a cost-effective way to provide a limited hedge against a lower market.
*As an alternative for those traders uncomfortable with exposure to a market crash, buying the way downside 90 put would “butterfly” this spread off and eliminate that exposure. This would of course increase the cost of the trade.
Photo Credit: L. Marie
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