A Practical Hedge Strategy as We Start a New Year!

poor-mans-covered-puts-SP500-SPY

On Monday I talked a little bit about the inherently bullish poor man’s covered call strategy using an example of a potential upcoming trade in the Dogs of the Dow. Today I want to discuss the exact opposite, a bearish income strategy, or hedge play known as the poor man’s covered put.

Most traders, or investors, either short stock, which has undefined risk and can be capital intensive or simply buy puts. However, in my opinion, a poor man’s covered put options strategy is a far superior way to take on a bearish position while defining you risk and using significantly less capital.

The trade mechanics of a poor man’s covered put is similar to that of a poor man’s covered call, but rather than using calls we focus on using puts.

Let’s go through an example step-by-step so we have a sound understanding on how a poor man’s covered put works in the real world.

Conceptually, poor man’s covered puts are similar to covered puts, with only a few exceptions.

Again, the main difference: poor man’s covered puts require far less capital. The strategy doesn’t require shorting 100 shares of stock. In fact, no shares are needed.

In most cases, it costs 65% to 85% less to use a poor man’s covered put options strategy. The savings in capital required should be reason enough to at least consider using the strategy. And I’m certain after reading this you will indeed find the options strategy appealing.

Like a covered put strategy, a poor man’s covered put is an inherently bearish options strategy. But again, rather than spend an inordinate amount of money to short at least 100 shares of stock, and have theoretically undefined risk, you have the ability to buy what is essentially a stock replacement. The replacement? An in-the-money LEAPS put contract.

LEAPS, or long-term equity anticipation securities, are options with at least one year left until they are due to expire. The reason we choose to use LEAPS as our stock replacement is because LEAPS don’t suffer from accelerated time decay like shorter-dated options.

The initial barrier to entry when it comes to selling poor man’s covered puts comes is security selection. Simply stated, implied volatility (IV) is one of the main keys to security selection. Implied volatility tells us how much risk and return we should expect to see over a 20- to 45-day time frame, so that we can form a realistic plan for creating monthly income.

Next is the price of the security. Just because the IV of a stock fits within our range doesn’t mean that the stock works. We must be able to establish a position while maintaining proper position size in our overall portfolio.

My preference is to buy a LEAPS (put) with a delta of roughly 0.80 and sell puts with a delta between 0.20 and 0.40. The reason is I want to give myself the ability to make some decent returns on my LEAPS contract if indeed the stock pushes significantly lower. My goal is to initiate my poor man’s covered put position with an overall delta of approximately 0.50.

stock-chart-poor-mans-covered-puts-SPY

If we followed the route of the traditional covered put, we would need to short at least 100 shares of SPY. At the current share price, shorting 100 shares would cost a minimum of $47,622. For some investors, the cost of 100 shares is prohibitive, especially if diversification amongst a basket of stocks is a priority. Therefore, a covered put strategy just isn’t in the cards.

But, as I said before, with a poor man’s covered put strategy you can typically save 65% to 85% of the cost of a covered put strategy, making the benefits of a poor man’s covered put strategy far more affordable.

So again, rather than shorting 100 shares or more of stock, we only have to buy one LEAPS put contract for every 100 shares we wish to control.

If we go with the longest-dated expiration cycle in SPY we are left with the December 20, 2024 expiration cycle with 1087 days until expiration. However, we can also go with the June 16, 2023 expiration cycle. The latter offers us the ability to bring in income while also not tying up as much capital. Of course, our duration is less on our LEAPS put contract, but we can always roll out further in time when our LEAPS has roughly 8-12 months left in duration.

You can see the expiration cycles currently offered for SPY below.

SPY-S&P500-expiration-cycles-poor-mans-covered-puts

Once I have chosen my expiration cycle, in this case the June 16, 2023, I then look for an in-the-money put strike with a delta of around 0.80.

When looking at SPY’s option chain I quickly noticed that the 540 put strike has a delta of 0.80. The 540 put strike price is currently trading for approximately $80.50. Remember, always use a limit order. Never buy an option at the ask price, which in this case is $81.90.

poor-mans-covered-puts-SPY-LEAPS

So, rather than spend $47,622 for control of 100 shares of SPY, we only need to spend $80.50. As a result, we are saving $39,572, or 83.1%. Now we have the ability to use the capital saved to diversify our premium or income stream amongst other securities, if we so choose.

After we purchase our LEAPS put option at the 540 put strike, we then begin the process of selling short-term puts against our LEAPS. This will allow us to not only create a steady income stream, but also lower the cost basis of our overall position.

My preference is to look for an expiration cycle with around 30-60 days left until expiration and then aim for selling a put strike with a delta ranging from 0.20 to 0.40, or a probability of success between 60% to 85%.

As you can see in the options chain below, the 460 put strike with a delta of 0.29 falls within my preferred range.

poor-mans-covered-puts-SPY-LEAPS-strategy

We can sell the 460 put option for roughly $5.91.

Our total outlay for the entire position now stands at $7,459 ($7,459 – $591). The premium collected is 7.3% over 51 days. A decent amount of premium, especially if you consider we are only going out 51 days.

But, if we were to use a traditional covered put our potential return on capital would be far less than half, or 1.2% over 51 days and we would be faced with unlimited risk, theoretically of course.

And remember, the 7.3% is just the premium return, it does not include any increases in the LEAPS contract if the ETF pushes lower. Moreover, we can continue to sell puts against our LEAPS position until there is roughly 10 to 12 months of life left in the LEAPS, thereby generating additional income or lowering our cost basis even further.

As an aside, an alternative way to approach a poor man’s covered put if you are a bit more bearish, is to buy two LEAPS for every put sold. This will increase the delta of our overall position and allow you to benefit from the additional downside past your chosen short put strike, yet still participate in the benefits of selling premium.

Regardless of your approach, you can continue to sell puts against your LEAPS as long as you wish. Whether you hold a position for one expiration cycle or 12, poor man’s covered puts give you all the benefits of a covered put for significantly less capital.

Poor Man’s Covered Put Trade:

  • Buy SPDR S&P 500 ETF (SPY) June 16, 2023 540 LEAPS put contracts for roughly $80.50
  • Sell SPDR S&P 500 ETF SPY) February 18, 2022 460 puts (51 days until expiration) for $5.91, or $591 per contract

Static or Return on Premium: 7.3% over 51 days, or 51.1% annually

Initial Breakeven: $74.59 or $7,459

So, as you can see above, we have the potential to create 7.3% every 51 days, or approximately 51.1% in premium a year using SPY.

Again, I will be issuing my ten Dogs of the Dow and Small Dog trades during the first week of 2022. If you wish to receive my 10 trades please make sure to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.

8 comments on “A Practical Hedge Strategy as We Start a New Year!

  1. Adrian on

    Andy, how about a roll strategy? Assumed, S&P rises and we collect premium three months one by one. However, hte LEAPS has lost more than the collected premium. Now, S&P falls sharply and our short put is losing. Even if the LEAPS has grown now, if I close both, I will still realize a nett loss, ..

    Reply
    • Andy Crowder on

      Adrian,

      Thanks for the question. I making a few assumptions when answering your question. Basically, you are assuming that SPY pushes slightly lower over the course of three months. So, we are losing value in the LEAPS contract, but still making money in our short calls. If the underlying falls sharply you can always hedge, but that would need to occur prior to the downturn. Otherwise, risk-management, through position-size is the best defense. Remember, this is an inherently bullish strategy that can still make money in a slightly bearish environment, but not every strategy works in every market environment, which is why risk-management is so important. So many people think that you can repair or adjust your way out of a loss. And remember, through selling calls we are creating a natural hedge for our position as we lower our cost basis each time we sell a call. Unfortunately, it just isn’t that easy and can take up a lot of time and capital when other, better opportunities are out there. Sometimes taking the loss and moving on is the best policy. I hope this helps.

      Reply
  2. Jock on

    As always, a great article. I have read lots of articles about the covered call but never the covered put. In the past 10 years, this strategy is definitely a loser overall on the major indexes since they have all gone up so much (I backtested and on the major indexes, it had a total loss of capital of many dozens of percent for that whole time, or several percent annualized – not all that bad given how much of a bullish market it was). It also failed on SPY over the past year as the S&P rocketed up 27%.

    But I found it interesting that this strategy backtested this past year really well on IWM, which was much more range-bound during the year but still increased 10% over the course of the year. The backtest (on edeltapro) made a 17% return over 333 days using a 500 DTE LEAP put at 80 delta and 40 DTE short put at 30 delta (or a 29% return at 40 delta). That’s pretty remarkable that a strategy that is fundamentally a bear market hedge might make you this much money in a somewhat up market.

    I wouldn’t put on a trade like this at all times but in dangerous market conditions like now and until the market gets at least a 10-20% haircut, absolutely I will put this trade on first thing Monday morning. I find it hard to believe the market can possibly go up a large amount further.

    Reply
    • Andy Crowder on

      Jock,

      Thanks for writing in and thanks for the kind words. As always, I appreciate the comment. Yes, when backtesting you will clearly see that a poor man’s covered call works well in a bullish, neutral, or even slightly bearish market environment. As for a poor man’s covered put strategy, it works well in bearish, neutral and slightly bullish markets. And in many cases, in a neutral to slightly directionally leaning market the covered put does better due to puts inherently having a greater IV than calls. This is because the crash-factor. Again, great comment and thanks for sharing!

      Reply
  3. Ankur Shah on

    Dear Andy,

    Wishing you a happy and prosperous 2022!

    Would it ever make sense to put on a poor man’s covered call and poor man’s covered put on the same underlying security? For example, could you place a PMCC trade on SPY, which is inherently bullish but at the same time place a poor man’s covered put trade to hedge downside risk?

    Reply
    • Andy Crowder on

      Ankur,

      Thanks for the kind words. Wishing you a happy and prosperous 2022 as well. In most cases I would say no, as there are other, cheaper ways to create a hedge. I plan on going over a few ways to hedge poor man’s covered calls over the next few weeks.

      Reply
  4. Bill on

    Andy, your weekly newsletter is a trove of great information, and the comments your readers are making are thought-provoking as well!

    Following up on Ankur Shah’s post: given his question and your comments on earnings strategies, it seems that a concurrent PMCC/PMCP, placed just before the announcement, where the short options are ATM, might work very well. What are your thoughts?

    Reply
    • Andy Crowder on

      Bill,

      Thanks for all the kind words. I truly appreciate it! You can read my response to Ankur’s question below. I would say there are better and cheaper ways to hedge a poor man’s covered call around earnings. I plan on going over a few ways in an upcoming post. Stay tuned! Thanks again!

      Reply

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