Insuring Against the Unexpected Upside Move

Well, Big Bad Ben certainly creamed the shorts yesterday with his completely unexpected statement that massive bond buying will not "taper" but will continue full speed ahead.

That gives me an opportunity about discussing another insurance use of options. We all know that puts are useful for insuring against a downside move. Calls are useful for insuring against an unexpected upside blowout like we saw yesterday. Also, calls can allow a stock investor to take profits and still say in the game.

 And, no, I don't mean using call options as a hedge against a short stock or futures position. That sort of thing is best left to professional traders. What I mean is as follows: Let's say that you have a varied portfolio of stocks and while you are very happy with the Great Rally of 2013 you are getting a little nervous about this lofty altitude and would not like to be caught when the euphoria ends.

So, you'd like to ring the cash register and lock in some profits, yet are afraid you'll sell too early (having said that, when Andrew Carnegie was asked how he made a fortune in the stock market he replied "I always sold too soon") and you would hate yourself if you got out and the market continued to roar higher.

You can liquidate all or most of your stocks and reinvest 10% of your profits in out of the money (OTM) index call options.

For example, let's say you own a broad based range of stocks and are well up, say 25% or more. You can sell your stocks, and take 10% of that profit and buy a four month out OTM SPY (S&P 500 ETF) call . At this writing with SPY at 173.50, you can buy the January 178 call  for 2.50. 178 is only 2.5% higher than we are now. If you sell your stocks you'll only miss the next 2.5% move higher before your call kicks in and starts making you money.

And, if you have, in fact, sold at or near the top then your small investment against a continued move higher was money well spent.

Either way, call options are not just a speculative tool to trade an expected move higher (although they can be), they also share the insurance properties of put options.

Another tribute to the great versatility of exchange traded options.

 

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