Jan 2010 Pullback

Last week (Jan 19th to 22th) we saw a pullback in all three major indexes associated with the uncertainty surrounding regulation for the banking industry and whether Fed Chairman would be confirmed for a second term.  Over a period of 4 days, the DOW dropped almost 500 points since it peaked on 19th Jan, which may have caused widespread panic amongst main street investors.  With a drop of this magnitude, investors usually react in one of the following ways:

1. Buy put options to protect their stocks holding (refer to the guidebook #1 for more information on this topic)
2. Close the position
3. Adjust the position

An investors’ reaction in this type of situation primarily depends on his/her investment style.  If you are risk averse, you may end up closing the position, but if you are somewhat optimistic, you may adjust your position.  However, before you make any decision, be sure to analyze your positional risk.  When panic sets in, even savvy investors can lose sight of their goal and close positions that end up being profitable.  Of course, we always have the benefit of hindsight.  However, as investors we must try to make an informed decision based on our risk tolerance and view of the market.  Let’s take a look the 1^st reaction listed above and closely analyze the factors that one must consider.

When a drop of this magnitude occurs, implied volatility rises, meaning that the market expects large price swings.  To account for these swings, the market marks-up the price of options.  This means that the time value or “extrinsic value” in an option becomes inflated and buyers end up paying more for options.  Also, the fact that people are rushing to buy put options also inflates their price to a certain extent because there is increased demand.  One way to counter the possible increase in volatility is to buy put spreads instead of put options.  Also, put spreads are cheaper in general than standalone put options because you end up buying an option and simultaneously selling another option. 

By buying a put spread, you are buying volatility at a high level and also selling volatility near the same level.  The two options counter each other and protect you from paying too much for the implied volatility built into the option price.  However, the one drawback of a put spread is that it gives you limited protection.  For example, if you own AAPL at $200 and buy a 190/180 put spread, you will have downside protection that starts at $190 and ends at $180, which is only $10 worth of protection.  Whereas, a 190 put option would have given you unlimited downside protection starting at $190, but you would end up paying a lot more in option premium to buy the 190 put option. 

These are some of the things that  you must consider before taking any action related to buying put protection for your portfolio.  Be sure to signup for the exclusive guidebook as it will walk you through protecting your portfolio from the time you initiate your position.