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Would you like to...

• Have a limited-risk way of profiting from falling stock prices?
• Be able to buy insurance on your stocks or overall portfolio?

You insure your house. You insure your car. Why don't you insure your portfolio?

Insurance for your portfolio - or any stock position - is available using put options. While options have the reputation of being risky assets in some circles, their original purpose was as insurance policies to protect positions, and buying puts is a limited risk way of doing just that.

Table of Contents

• What is a Protective Put?
• Rules for Buying
• Exiting Long Puts
• Example of a Winning Trade
• Example of a Losing Trade
• Summary

What is a Protective Put?

Puts make money when the underlying stock goes down, and therefore when owned along with the underlying, provide downside protection. As a buyer you limit the risk of stock ownership. Just as with your other insurance policies, your risk is the premium you pay. And like your other insurance policies, you have it in place with the intention of not using it.

A protective put requires you to identify the strike price and the expiration date that you want, and to purchase the option. This is as easy as picking a stop-loss point, usually involving an out-of-the-money put (a put strike that is below the stock price) which restricts the loss to a size that you are comfortable with. Add the cost of the option to the difference between the stock price and the strike price, and that is your maximum loss to the downside. And for those stock traders familiar stop-losses, there is no slippage and no gaps down past your stop price.

As options are expiring assets, they are also decaying assets. There is a time value component to the premium price of an option and every day that amount decreases. The decay rate also increases as expiration approaches. Longer-term options decay at slower rates than short-term options, so most investors use longer term puts for protection, and sell them before the decay rate increases dramatically (usually in the last 30 to 45 days).

For example, if you own 100 shares of EBAY at $31.00 and want to protect your position, you could buy a four-month 30 strike put for $2. Below $28 (the strike minus the premium cost of the option), you are protected dollar for dollar against stock declines.



Below, a profit and loss diagram of a long stock position with a protective put at expiration. We have already discussed the fact that you don't want to hold this position until expiration, so let's look at the position half way until expiration (with no change in implied volatility):



In this second P/L chart, we can see that EBAY would have to drop all the way to 28 to produce the maximum loss of $300. An increase in implied volatility would help the position and therefore would lower that price at which the maximum loss occurs.

If the stock moves up to $36, a gain of $300 is produced. Again this will be impacted by a rise or fall in implied volatility.

Finally, if the stock remains unchanged, time decay will eat away at the options value and will produce a small loss (the cost of insurance).

Stock Price	Stock Gain/Loss	Put Gain/Loss	Total Gain/Loss
$36	$7	($2)	$3
$31	$0	($2)	($2)
$28	($3)	$0	($3)
$25	($6)	$3	($3)

Rules for Buying

Regardless of whether you are buying calls or puts, there are some general rules to follow. One, the expiration should give the option enough time to perform without being overexposed to time decay. Since options have an expiration date, a large part of their value is time value (for more, see our lesson on Options Pricing). This time value will deteriorate as that expiration approaches; time decay increases exponentially in the last 30 to 45 days of an options life, so this is usually not the time to own options.

Two, options should generally be bought when the time value - primarily influenced by a factor known as implied volatility, or the expected price swings of the underlying - is expected to stay flat or to rise. Buying options is a limited-risk strategy, and all of that risk lies in the premium paid for the option. If there is a rise in implied volatility, then there will be a rise in the option premiums. This increase can produce profits for long options, even if the stock price doesn't move, because the chance of movement has increased. Conversely, if you buy options when implied volatility and premiums are high, such as before earnings, then the stock can move in the direction that you want and you can still lose money, because with the news out, the implied volatility could fall.

Finally, when you buy an option, generally you will want to sell it, ideally for a still-greater premium. You do not want it to expire, since you will receive zero premium, and normally you don't want to exercise your right to purchase the underlying shares, unless that is your particular strategy (say for tax reasons). In both of these cases, you lose whatever time value is left in the option. So with future resale value in mind, we can see why risk management rules are important, such as taking profits when your position doubles or closing out the position when it loses half of their entry value.

Exiting Long Puts

When a put has been purchased, the position can be closed in one of three ways:

• Selling the put - Once a put is bought it can be sold at any time, and this is the most common way of exiting a long position. This is the only way of exiting a long position that captures any remaining time value in the option.
• Letting it expire - If a put gets all the way to expiration, it will expire, worthless if it is out of the money (when the stock price is above the strike price - See Options Pricing). If the stock price is below the strike price by $.01 or more, it will be automatically exercised and shares will be "taken" from your brokerage account. Long options are almost always sold before expiring, as at that point they will have lost all time value.
• Exercising the option - Utilizing the "right to sell" that is inherent in the put contract is known as exercising the option. This delivers shares of the stock from your account at the strike price. Options are rarely bought with the intention of exercising the underlying right. Taking this course also forgoes any remaining time value in the option.

Example of a Winning Trade

• In the circled area, QQQQ price hits resistance at the same time that implied volatility bottoms. Ideally we want to buy puts on low implied volatility because that provides for more time decay, which is in our favor.
  
  
• Time decay is the greatest in the front month and for strikes near the money, so in this case, with the stock hitting resistance at 52.50 and implied volatility at 21% we would buy three months out: March 50 puts for $.95.
• If the underlying price falls, and implied volatility rises (as was the case), the put protection kicks in.
• In this case, the stock hit $43 within a month and implied volatility went to 34%. The option went from $.95 to $7.25 even with a month of time decay, providing exactly the protection we desired.
• Using disciplined position management, we would have exited this position before the full gain, taking half of the position off after a 100% gain, and selling most of the rest at a 200% gain. The reason to do so is to avoid letting a winner become a loser - since we could not have known the future trajectory of the option.

Example of a Losing Trade

• The worst thing that can happen with protective puts is a sideways market, especially if implied volatility falls.
  
  
• Using the same underlying as on the previous page, if we had bought puts three weeks earlier, the trade might not have worked out as well. In the highlighted area we see the QQQQ making a lower high and implied volatility off of its highest levels. But most options traders ignore implied volatility and buy out-of-the-money calls only in the near months.
• So with the stock at 52 and the implied volatility at 27%, we could have bought the January 51 put with for $1.30.
• The position showed a small profit after two weeks as the price dropped and IV went up. But then both reversed. The price went up to 52.50, and the implied volatility dropped to 21% (our entry in the above example). The price is basically at the same point and implied volatility dropped, so we have made no money on the price direction and we have lost money on the protective put.

Summary

• Long puts can be used to protect holdings or portfolios as insurance.
• They can be a limited-risk way to profit from downside moves in the underlying.
• They are significantly affected by implied volatility and time decay.
• When long puts are used as protection for a stock holding, they are equivalent to a long call.
• The maximum risk is capped; the maximum gain is unlimited to the upside.

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Options data for Thermal Imaging™ provided by Wolverine Trading Technology, LLC. Market data powered by QuoteMedia, fundamentals by Hemscott. All data delayed by 15 to 20 minutes unless otherwise indicated.

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Copyright © 2008 OptionMonster® Holdings, Inc. All Rights Reserved
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