Tuesday, July 22, 2014

Trying out the Protective Put Option Strategy

Earlier in this blog, I noted that my asset allocation was no longer correct due to stock price increases and other factors, see this post.  I need to sell some small cap investments and buy more bond investments.

Well it turns out that selling my small cap ETF this year would incur large taxes.  If I sold next year, my tax would be much lower.  But I should rebalance now, not next year.  How can I reduce the risk of having an unbalanced asset allocation?

One idea that I am toying with is to purchase a "Protective Put" option against my small cap ETF.  You buy a Put option below the current ETF price that expires early next year.  If the ETF goes up, all is good as you get the capital gains and sell the ETF next year, but the option may be worthless.  If the ETF price goes down, your Put option gains in value at roughly the rate that the stock price falls, so you sell the Put and the stock next year and you do not lose as much.

The graph above shows a protective put for a position where you own a stock priced at $60, and a December Put option at $58.  The $6000 investment loss is capped at -$427 (the price of the Put option), but has upside potential.

What do you think of this approach?  Does it make sense given my circumstances?

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