Using options to protect your portfolio

By Brett Thompson, Shaw Stockbroking

Over the past few months we have seen history made in world financial markets. For investors and traders alike it's been a torrid time, with volatility running at unprecedented levels, massive daily share price swings and copious amounts of news to absorb, mostly of which has been negative. There has been so much happening in such a short passage of time it's almost become overwhelming.

I doubt I need to remind readers that this year our market has fallen by 35 per cent, or nearly 2,800 points, from its November 2007 high. When will it end, you may ask, and is this near the bottom? The short answer is no one can be 100 per cent certain and it's uncertainty that will drive share prices well below their real valuations.

With so much unpredictability, do we have greater upside potential than downside? And, if so, how can you buy at a discount, or participate, while conserving capital in case the falls continue? Exchange-traded options may help provide the answers. There are a multitude of strategies at your disposal.

The back spread in volatile markets

This bullish breakout options strategy has unlimited upside from a rising share price but limited loss potential. It is created by the sale of the lower strike price and buying two or more calls at a higher strike price. The ratio of longs against shorts can be adjusted depending on your view.

Ideally, the spread should be established for a credit or small debit. If the position were established for a credit, then profit potential could be gained to the downside as well.

The reason this strategy has the potential for unlimited upside is because you will be holding more long call options than short calls.

Why would you choose this strategy over buying a call option or the just underlying shares?
If you wanted to take advantage of a possible share price rebound, but were concerned that the share may continue to fall, then the call option back spread may be your answer. Due to a lower initial outlay, it carries less risk and uses much less capital than simply buying the underlying shares or a call option.

Applying the back spread

To apply the trade - using Amcor as our example - you could sell a 1 December $5.25 call at 46c and buy a 2 December $5.75 call at $0.19c as demonstrated below:

Initial trade

By applying theoretical pricing to these two examples below it demonstrates how the strategy would perform if closed out in two weeks with the shares at $5.87 and $6.07 respectively.

If the initial trade was done for a credit such as the scenario above ($80) then this is also added to the net credit received in these examples.

Example 1 - Shares up 50c and you close the existing position

Example 2 - Shares up 70c and you close the existing position

AMC - Monthly line chart

If all goes to plan and the shares rally, then you could either take profits as shown above, or roll your long calls to a higher strike, leaving your short position where it is - offering good downside protection if a fall should happen within your expiry cycle.

Should expectations not be met and the share fails to rally, then the maximum potential loss would be $420, which is the difference between the two strike prices less the $80 premium received. If the share closes at or below $5.25 on expiry then the initial credit is retained.

Positives and negatives

Volatility or lack of it and time decay are the main risks to this strategy. You are relying upon a quick upward price rise in the underlying share for this breakout strategy to be effective. With current market conditions as they are, price stagnation and flat volatility may not be that likely.
Benefits are low cost/no cost, open-ended profit potential and being able to calculate exactly what your risk/reward scenario will be before the strategy is taken. Margins may apply and should be considered before entering into this trade.

Conclusion

As the profit is open-ended, the ratio back spread is a strategy worth considering before tying up valuable capital for the purchase of shares. Remember, cash is king and in this current climate it's good to be the king.

About the author

Brett Thompson is an advisor at Shaw Stockbroking with Level 1 and 2 Derivative Accreditation. If you would like to contact him regarding this article or any other trading related matters, email bthompson@shawstock.com.au or phone (02) 9238 1238.

From ASX

To learn more about a range of options strategies, read the free ASX guide Options Strategies - 26 proven options strategies for clever investors (PDF 170KB). The ASX Options Library also outlines a range of bullish, bearish and neutral strategies, as well as strategies for price breakouts. There are also a number of options strategies that were published in ASX Investor Update over the past few years.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX").  ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content.  The content is for educational purposes only and does not constitute financial advice.  Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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