Option Block 372: Call Stupids and Bond Hedges

Trading Block: Alibaba IPO on Friday. Fed Meeting on Wednesday. Scots vote whether or not to stay in UK.

Odd Block: Calls trade in Energy Transfer Partners (ETP) ratio spreads in Petroleo Brasilieiro Petrobras (PBR), put buyers jump into PDL Biopharma Inc. (PDLI).

Mail Block: Listener questions and comments

Question from Lawrence Silverberg - Hi! “Doctor Larry” back again. Thanks for reading and answering my previous two questions / comments on the show! I’m a huge fan! I am considering a way to insure my bond portfolio with options. Honestly I'm not too concerned with rising interest rates in the next two to three years but I understand the risk exists. Additionally, a market crash seems like a bigger risk to me. Either way I see bonds having downside risk.

Here's my thought process below: I'd love to hear your comment.

Situation: I'm about 8-10 years to retirement. I have about 80% of my savings in just below investment grade bonds. These are big companies like Goodyear, Burger King, US steel, Morgan Stanley, Levi’s, Hertz, Ford, and many more. It's a very diverse bond ladder. Average return is just under 7%. They have appreciated a great deal over the past 8-9 years too.

By rule of 72 I'm doubling my money every 10-11 years with interest. Hopefully faster with appreciation of the bonds too. The risk is if there is a period of rising rates (although I plan to hold to maturity) or a market crash like what happened in 2008.

I was considering insuring this portfolio with LEAPS in HYG. A high yield bond EFT. It appears to be the most liquid options compared to other similar bond ETFs. As for stock volume it is second to only JNK.

I can buy the Jan '16 puts ATM pretty cheap. These Leaps are trading at less than a 10% Implied Volatility. In the 2008 crash, HYG went from 105 to 65 and IV went from 10 to 22%. (NOTE: HYG TRADING $93 & JAN 2016 93 PUTS OFFERED @$9.30 - SO HAVE TO BE WILLING TO SPEND 10% OF YOUR HOLDING ON PROTECTION)

I did not want to just buy puts naked but was looking at backspreads. This way I’m selling premium to get much less short theta and I’m buying more puts to get long Vega and short delta.

The best spread I found was a Jan16 put backspread 1 by 4. Short one 85 put for each long four 70 puts. With theoretical pricing I can put the spread on for even money and possibly a $0.10 credit. I’d close this spread when the Jan 17 leaps are listed and add 12 more months of insurance.

In summary, I have some upside risk as IV can go down to around 5% based on history but that’s the cost of insurance. When I roll to Jan17 I’d lose some money.

Questions:

How do I weight a bond portfolio to figure out how many contracts to trade?

Similarly, how do I estimate downside risk of the bonds?

Is HYG my best underlying?

Is there a different spread that’s long Vega and short delta that you’d recommend?

Would you use a diagonal instead of trading only one month? I can get a similar protection by trading a 1 by 2 diagonal. Short one Dec 90 put for each long two Jan 2016 $85 puts for around even money. I could then sell more (90 *or other strike) puts when the Dec expire. My hesitation here is that it’s harder to predict IV of two months. I think the short Dec will increase IV in a crash more than my long Jan16 and hurt performance.

If you read this (long) question on the air I’d really appreciate it. “Dr. Larry.”