Volatility, especially downward, comes in bunches. That's what history tells us, so the next few weeks could see severe selling. Big money is leaving the market and for good reason. The rise has been attributed to fed stimulus, but that is winding down, and the earnings reports of big names and market leaders have been unable to turn the tide. So what actions can an investor take without worrying about their portfolio and wealth?
The simplest thing to do is to sell your holdings. But for long-term holders, this might not be practical. They may be in dividend-reinvestment programs and would appreciate the slight drop in valuation. Others may want to always be participated in the market for any eventual rally. Or perhaps investors don't want to realize any tax gains until retirement, especially if they are planning to get back in the market. This is where the option market comes in, and why I have always been an advocate for it.
The endless array of strategies that exist in just two products should persuade many investors to get a basic understanding of how they work. The covered call can introduce monthly or weekly income immediately in cash so any taxes owed at year-end can be simply withdrawn from the account. But covered calls are only half the answer. Today we are going to introduce the married put.
Let's say you have owned Google (GOOG) shares for 5 years now, buying after the market crash of 2008 and you bought 100 of them for $380 a share ($38,000). Those shares today are worth $1,137.50 each ($113,750). Well, cashing in would create a capital gain of $75,750. But you truly believe in the stock, so if you sell today and bought a 100 shares in a few weeks at roughly the same price, you would still owe taxes. Instead, you can essentially lock in that $1,137.50 price without having to worry about the movement of the market for the next several weeks using a married put strategy.
The strategy is implemented by selling a covered call and using those premiums to purchase a put. Let's say a trader wants protection until the end of February, they would find February 28, 2014 options and sell the call for at least $28.80 a contract ($2,880) and buy the put at the same strike price costing at most $29.80 a contract ($2,980). The overall cost of the "insurance" is at most $100. The reason for this is because we sold at the bid (highest shown buyer) and bought at the ask (lowest shown seller), which in reality, is the worst case scenario and better fills often exist.
So, here's why it works. Let's say today is now Feb 28 and the shares fall to $1,100. The covered call would be worthless, and the trader would NOT exercise his option, but simply sell it for about $37.50 ($3,750). This would create a profit on the put option of $770. The profit on the call is the entire $2,880. A net profit of $3,650. However, the shares of Google have fallen $37.50, so the equity value has dropped $3,750. The total loss of equity is $100, the cost of the option.
Let's use a table to demonstrate this.
| Date | Google Value | Cash | Equity |
| Feb 3 mid-day | $113,750 | $0 | $113,750 |
| Feb 3 close | $113,750 | -$100 | $113,650 |
| Feb 28 close | $110,000 | $3,650 | $113,650 |
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