Adding Protection

Add Cheap SPY Puts

By Bryan Bottarelli
Tuesday, April 17, 2007 2:09 PM EDT
Tue, 17 Apr 2007 18:09:00 GMT

Dear Bottarelli Research Member,

A quick look at our current trading portfolio shows a heavy bias towards upside calls. Now I must admit, this bias so far has been correct — as the Dow closed higher in 12 out of the last 13 trading sessions. But now that we’ve once again reached the levels that sparked the steep sell-off this past February, I think it’s a smart idea to add some downside protection in the form of SPY June 150 Puts (SYH RT).

I particularly like these puts because — compared to other in-the-money index options — they’re relatively cheap. As I write, they’re trading between $3.80 and $3.90 per contract, but here’s the thing to remember. Since these SPY puts are in-the-money by $3.08, this means you’re paying only $0.80 to carry this downside protection into June. When you break it down, that’s only $0.40 a month to own this downside exposure — which I feel is absolutely worth the price.

SPY

As a base-line calculation, these puts could increase by 23% for every 10 points the S&P 500 moves down. So looking at the chart above, a re-test of the 50-day moving average at 143 could increase these puts up to $6.40, good for a 68% gain from current levels. To me, I’d like to add this protective position to our ledger at current levels. Here’s the protective play:

DOWNSIDE PROTECTION: Buy the SPY June 150 Puts (SYH RT) at or under $3.90, good for the day. Place a protective stop loss at $2.00.

*Trading Note: When it comes to protective positions like this, buy a smaller amount of contracts that you typically would with a standard options play. Remember, the point of insurance to pay the least amount of premium to achieve the maximum amount of coverage, so account for this in your contract sizing.

Also catching my attention today is Pulte Homes (PHM – NYSE). Today’s new home construction figures increased 0.8% in March to a seasonally adjusted annual rate of 1.518 million. Although this certainly isn’t a blowout number (as analysts were expecting the number to be 1.50 million), this is still the highest level this year. That brings about renewed optimism that the worst of the housing correction in over — and perhaps set a floor on stocks like PHM. Check out the chart:

PHM

Going forward, it might be a good idea to add longer-dated call options on Pulte Homes, but for now let’s wait a little longer. When it’s time to act, you’ll be the first to know. Until then…

Lock and load!

Sincerely,

Bryan Bottarelli

Bryan Bottarelli
Editor, Bottarelli Research

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