With the stock market in a correction, it can be an excellent time to think about portfolio protection.
XDespite Wednesday's robust rebound, we want to see more stocks getting back above key technical levels before going back into full bullish mode.
That being said, traders with a large bullish expose may want to consider adding some protection.
One way to do that is via an options trade known as a ladder.
Using VIX To Hedge Portfolio
Let's look at an example using options on the Cboe Market Volatility Index, commonly known as the VIX.
To set up a call ladder, we sell an at-the-money call option. Then buy an out-of-the-money call and another further out-of-the-money call.
We receive a credit from selling the at-the-money call and pay debits for the two out-of-the-money call purchases.
The goal is to place the trade at zero cost, or at worst, a small debit using the VIX index options.
Using the November expiration, that might look something like this:
Sell 1 Nov. 16, 30 call at $3.90
Buy 1 Nov. 16, 35 call at $2.80
Buy 1 Nov. 16, 50 call at $1.25
We receive $390 for selling the 30-strike call and pay $405 for buying the 35 and 50 strike calls.
Trade Offers Protection Against Volatility Spike
Therefore, the trade meets the criteria of being placed for a small debit of $15.
This trade will give some protection in the event of a large spike in volatility in the coming weeks.
I would typically hold this hedge trade for around two weeks and then close it out if it is no longer needed.
VIX options behave slightly differently from stock options, so make sure you understand how they work before risking any capital.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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