Thursday, May 29, 2008

Protective Put Pesto on the Energy Sector

In Recipe #3 we looked at portfolio hedging techniques, including using put options on ETFs as a way to hedge the portion of your portfolio that's heavily weighted in one particular sector. Now, the energy sector has been a stellar performer this year, but rampant speculation has many Wall Street analysts worried that it might be setting up for a nasty tumble. Their concerns may be justified as oil dropped over $4/barrel just today.

So what's an investor who's heavily weighted in energy stocks to do? If you're in this boat and you still want to hang on to your positions, one strategy that can help you sleep at night is to purchase puts on the XLE, the Energy ETF.

The method that I'm proposing here isn't restricted to the energy sector. If you have significant holdings in any sector--be it healthcare, international stocks, software, networking, biotech, etc.--it's well worth purchasing some insurance on it especially if that particular sector is looking a little “toppy” as is the energy sector right now. Now not all ETFs are optionable, but most are. The XLE especially offers highly liquid options which makes this an attractive candidate on which to purchase protective puts. Let's consider an example on how this strategy would work.

Protective Put Example
Let's say that you have a portfolio of oil and gas stocks worth $50,000. You think that the price of oil will continue to climb over the long term but you're concerned that the speculation bubble might burst causing a price tumble in the near future. You can protect your position by buying at-the-money (ATM) puts on the XLE. Currently, the XLE is trading near $87 with one September 87 put trading at $6.80. Since one options contract represents 100 shares of the ETF, the value of a single contract at $87 is $8700.

In order to fully shield yourself from a price downturn, you'd need to purchase 6 put options ($50,000/$8700 = 5.75) to fully protect yourself. (You could buy only 5 contracts but then you're not completely covered.) The total cost of this insurance is 5 x $6.80 x 100 = $3400 which is 6.8% of your portfolio's value. This may seem a high price to pay, but consider the consequences. Suppose oil does fall in the near future resulting in your portfolio losing $5000, or 10% of its current value. What are your options going to be worth?

The answer is that it's difficult to pinpoint the value exactly since neither will your stocks march lock-step with the price of oil nor will the XLE. Comparing the chart of XLE to the chart of light sweet crude shows that the XLE does indeed follow the price of oil fairly well. When oil dropped a certain percentage, so did the XLE by roughly the same margin. That means if oil drops by 10%, then the XLE will drop by roughly the same amount. Using my handy-dandy Black Scholes options calculator and assuming that this 10% drop occurs a month from now, the value of your puts will be roughly $11 per contract. Since you have 6 contracts, that's a total value of $6600. You paid $3400 for the insurance giving you a net profit of $3200. That doesn't quite cover the loss in your portfolio, but as I said, it's difficult to gauge the exact numbers here, and it sure beats not having any insurance at all.*

I hope you take the time to understand this strategy, especially if you have a lot of money placed in the energy sector. Tomorrow, I'm hoping to get back on track with the results of my stop-loss research, but I felt that today's drop in oil prices warranted the resurrection of the protective put recipe.

*Technical Note: In calculating the expected value of the XLE put option, I used today's value for the option's implied volatility. This value can change and will affect the results. An increase in volatility will raise the price of the option and a decrease will do just the reverse. If you're unfamiliar with options this will have no meaning for you which is why I strongly encourage anyone who wishes to use options to learn about them first. (See the links at the top.)

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