On another forum, an investor asked for an idea to protect against a 10% decline. My reply:
"I'm not defending myself against a 10% pullback, in large part, because I don't guess the market. But if I wanted to defend against a 10% pullback, I might sell a cash secured put against SPY, the ETF that holds the S&P 500. An example:
SPY is trading at $444.45; close to an all-time high. A 10% drop would take it to $400. To be defensive, I'd sell an SPY put with a $400 strike price that expires on 12/17/21. The buyer of that put would pay me $7.10 (per share). This put buyer is often a speculator that's making a guess that SPY will fall toward or below $400 between now & 12/17/21. That $7.10 would be paid to my account tomorrow & it's non-forfeitable. It's mine. I could spend it on investments, gasoline, groceries.
But the $7.10 isn't free to me; there's a catch...an obligation for me: if SPY drops below $400 between now & 12/17/21, I'm obliged to buy SPY at exactly $400. Even if it drops to $390, or to $300 or to $0 (the risk of this idea). When I'm forced to buy it at $400, my cost basis is $400 minus $7.10 = $392.90.
I do not have to own SPY shares to make this trade. But I must hold $400 cash (per share) in my account to secure the $400 buy obligation.
If SPY stays above $400 until 12/17/21, the put option expires, & my obligation to buy SPY at $400 ceases. All I have earned is the $7.10. What's my return if SPY doesn't drop to < $400?...$7.10 divided by the $400 on reserve = 1.8% for about 4 months, which annualizes to over 5%.
If SPY drops to < $400, I'll be obliged (forced) to buy SPY at $400, a 10% discount from today's price. (Actually, at $392.90!)
A pure defensive move against a 10% drop would be to stay in cash. And then, after SPY drops to $400, buying it at the 10% discounted price. Selling these cash secured puts pays you $7.10 while you wait for the 10% correction."
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