How to Use Options to Hedge Against a Stock Market Correction

By: Money_Morning

Larry D. Spears writes: Stocks have been mostly higher the past five months, with the Dow Jones Industrial Average recently topping 13,000 for a few days and the Nasdaq Composite touching the key 3,000 mark on the final day of February.

However, the markets have turned erratic the last week or so, and big moves like last Tuesday's plunge have left many investors to worry about a looming stock market correction.

Normally, that would send options-savvy investors in search of protective puts so they could lock in profits on their long stock positions.

In doing so they essentially are buying an "insurance policy" that would pay off should prices indeed turn lower in the next couple of months.

But, as readers who checked out Money Morning writer Don Miller's Wednesday article on the VIX Indicator, which measures trading activity in options on the Standard &Poor's 500 index - and, by association, options on individual stocks comprising the major indices - last week's jump in volatility sent put prices sharply higher.

In fact, the VIX Indicator itself jumped from just 16.83 on Feb. 23 to a reading of 20.84 on Tuesday.

And, though it has pulled back a bit since, the volatility means merely buying protective puts at this time would be a fairly costly proposition.

As an example, assume you hold 100 shares of stock in Las Vegas Sands Corp. (NYSE: LVS), having happily watched as the market's rally carried its price from an Oct. 3, 2011, level of $36.71 to a March 1 high of $56.82.

However, the $3.33 decline by LVS last Monday and Tuesday leaves you little doubt the stock would be vulnerable in any upcoming stock market correction.

And even though the stock rebounded to $55.29 by Thursday's close, you still feel like you need a little protection for your paper profits.

So, what do you do?

How to Protect Yourself Against a Stock Market Correction
As noted above, the first inclination is to look at the purchase of a protective put option.

But, because of the increased volatility, put premiums have risen sharply. To be precise, the at-the-money June $55.00 LVS put, which expires on June 16, was quoted late Thursday at $4.28 a share - or $428 for the full 100-share contract.

At that put premium, the price of Las Vegas Sands stock would have to fall to $50.72 ($55.00 - $4.28 = $50.72) before you'd get any protection, meaning you'd give back $457 of your present gains. The cost of the hedging put would also offset any additional gains on LVS stock up to a price of $59.57 ($55.29 + $4.28 = $59.57).

Not the most effective insurance policy by any means.

But, fortunately, there's a more attractive - and far less costly - alternative.

It's a triple-pronged hedge that still involves buying a protective at-the-money June $55 put, but offsets the cost - and greatly lowers the risk - through the simultaneous sale of both an out-of-the-money LVS put and an out-of-the-money LVS call option.

Sale of the second put - in this case, a June $50 put - creates a bearish spread that will insure your LVS position, almost completely offsetting any drop in the price of the underlying shares to that strike price level.

The sale of the call - in this instance, a June call with a $60 strike price - brings in enough added money to offset most or all of the cost of the put you buy for protection.

And, as a bonus, it also allows you to pick up a limited amount of additional profit should your concerns prove unfounded and the LVS stock price continue to rise.

This combination carries no additional margin requirement because the stock you hold covers the call you sell, and the at-the-money put you buy as insurance covers the put you sell.

Breaking Down this Three-pronged Hedge
To clarify, let's look at some actual numbers, based on Las Vegas Sands option prices available shortly before the close last Thursday, when you could have:

•Purchased the June $55 LVS put at $4.28, or $428 for the full 100-share contract;
•Sold the June $50 LVS put at $2.28, or $228; and,
•Sold the June $60 LVS call at $2.19, or $219.
Those three transactions would have actually given you a small net credit of $19 ($2.28 + $2.19 - $4.28 = $0.19, or $19), plus you'd have created a three-pronged hedge that:

•Locked in all but $10 of your current paper profit at any LVS stock price from the current level down to the $50 strike price of the put you sold;
•Reduced your potential loss to less than half the loss on the stock itself should the LVS price drop below $50 a share;
•Allowed you to add up to $490 in additional profits - slightly more than on the stock alone - if your concerns proved wrong and LVS rallied again, climbing to $60 a share. (Your additional profit would be limited to $490 since losses on the call you sold would offset gains on the stock at any LVS price above $60 a share.)

To clarify these advantages, the accompanying table shows all the possible outcomes for this strategy at any Las Vegas Sands Corp. price between $45 and $65 per share (assuming the positions are held until the option expiration on Friday, June 16, 2012).

Picture of a Triple-Pronged Option Hedge
The table below shows the possible outcomes for a triple-pronged hedge position on Las Vegas Sands Corp. at various stock prices on June 16, 2012. The analysis uses the example of a 100-share lot of stock and single June put and call options, all priced at late-day levels on Thursday, March 8, when LVS was trading at $55.29 a share.

This hedging strategy will work equally well with almost any stock priced above $20 a share. It also works across differing time frames, though the amount of downside protection on shorter-term hedges will be reduced by the smaller time premiums for the options.

Obviously, if your concerns prove to be unfounded and the stock you're hedging resumes its upward course, this strategy will limit your future profits (unless you buy back the call you sold). However, if you have gains on an existing position, this strategy can be a highly effective means of protecting yourself.

And, depending on the strike prices and premiums of the out-of-the-money options you choose to sell, you can protect your gains against a stock market correction at little or no cost.

Source http://moneymorning.com/2012/03/13/how-to-use-options-to-hedge-against-a-stock-market-correction/

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