When a
Boeing
jet door flew off at about 16,000 feet in the air and everyone was panicking, an intrepid passenger logged into his brokerage account to buy Boeing put options. By the time the plane had landed, the news had hit Boeing stock, and the puts were worth a fortune.
The story, alas, exists only in the imagination of some traders who made a meme about what they hoped they would have done if they were on that Boeing jet.
That’s the thing about trading: Almost no one stays calm when chaos erupts. In fact, investors usually freak out when the unexpected occurs. They become insensitive to put prices and will pay almost anything to hedge a falling market, which delights market makers who seek to mint fortunes from fear. (Puts give holders the right to sell an underlying asset at a set price within a defined period.)
Just as surely as the stock market opens at 9:30 a.m. in New York, it can be stated with equal confidence that the Four Horsemen of the Apocalypse would need to appear on the corner of Wall and Broad streets for puts bought in panic to prove profitable. But scary markets prompt people to try to create a financial sense of security even if it is economically ridiculous.
We recently noted that investors are so self-satisfied that something as dramatic as Boeing’s latest mishap is needed to shock them into acknowledging the risks that increasingly define the world. If you agree with that thesis, the riddle becomes how to hedge against losing your unrealized gains—which presumably are at record highs for most people, given that the markets are at record levels—without being made a fool of by the market.
We continue to believe that the best way to hedge your bets is by selling puts on winning stocks when chaos erupts. This lets you become a dealer and sell overpriced puts to scared investors.
A more common—if trickier—approach is hedging before chaos erupts. Many things must go wrong for this type of hedge to go right. Put spreads—which entail buying one put and selling another with the same expiration but lower strike price—are an attractive strategy.
There isn’t a one-size-fits-all approach to trading a put spread, but a reasonable starting point is to focus on puts that expire in two months. That expiration period covers enough time for something to happen, but not so much time that investors pay a fortune to cover many potential outcomes.
Construct hedges with a put that is about 10% below the stock price. As we have often said, the first 10% decline belongs to the market. (If you can’t handle a drop like that, you probably shouldn’t even own the stock you are trying to hedge.) Sell another put with a lower strike price. The goal is to create a spread that could generate a return of 100% or more.
Consider the
Technology Select Sector SPDR
exchange-traded fund. With the ETF at $201.86, the March $180 put costs about 64 cents and the March $170 put sells for about 40 cents. If the ETF is at $170 at expiration, the 24-cent hedge is worth $9.76.
The hedge fails if the ETF rises and the bulk of money spent is lost. The hedge can be reset at another two-month interval with updated strikes that reflect market changes.
The approach has drawbacks. Resetting hedges is expensive if the market drifts higher, which can easily happen in kinetic environments.
Should the hedge prove profitable, don’t be greedy. Take profits. Many investors fail to do that because they are excited by their success and think they will make even more money than they already have.
The predetermined outcome of spread strategies mitigates that danger, but greed, like fear, does strange things to people.
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