Your Inside Source for Options Information

October 15, 2018

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The risks and rewards of using protective (or married) puts

Description

A long put option added to long stock insures the stock's value. The choice of strike prices determines where the downside protection 'kicks in’. If the stock stays strong, the investor still gets the benefit of upside gains. (In fact, if the short-term forecast brightens before the put expires, it could be sold back to recoup some of its cost.) However, if the stock falls below the strike, as originally feared, the investor has the benefit of several choices.

One option is to exercise the put, which triggers the sale of the stock. The strike price sets the minimum exit price. If the long-term outlook has turned bearish, this could be the most prudent move.

If the worst seems to be over, an alternative for still-bullish investors is to keep the stock and sell the put. The sale should recoup some of the original premium paid, and may even result in a profit. If so, it in effect lowers the stock's cost basis.

EXAMPLE

• Long 100 shares XYZ stock
• Long 1 XYZ 60 put

MAXIMUM GAIN

• Unlimited

MAXIMUM LOSS

• Stock purchase price - strike price - premium paid

If the investor remains nervous, the put could be held into expiration to extend the protection for as long as possible. Then it either expires worthless or, if it is sufficiently in-the-money, is exercised and the stock would be sold.

The put can provide excellent protection against a downturn during the term of the option. The major drawback of the strategy is its cost, which raises the bar on netting upside profits. Investors who aren't very bullish might have better strategy alternatives.

Outlook

This investor is bullish overall, but worries about a sharp temporary decline in the underlying stock's price.

If the investor is worried about the longer-term prospects also, other strategy choices might be a covered call or liquidating the stock and selecting another.

Summary

This strategy consists of adding a long put position to a long stock position. The protective put establishes a 'floor' price under which investor's stock value cannot fall.

If the stock keeps rising, the investor benefits from the upside gains. Yet no matter how low the stock might fall, the investor can exercise the put to liquidate the stock at the strike price.

Motivation

This strategy is a hedge against a temporary dip in the stock's value. The protective put buyer retains the upside potential of the stock, while limiting the downside risk.

Some examples of when investors consider protective puts:

• Before an imminent news announcement that could send a favorite stock into a slump.
• When it's vital to insure the value of a specific stock for a certain period; for instance, to cover a house down payment or tuition outlays five months from now.
• When one stock represents a large percentage of the investor's portfolio.
• When an investor is restricted from selling a particular stock for some time period.
• When a stockowner wants to protect substantial unrealized gains.

Variations

The married put and protective put strategies are identical, except for the time when the stock is acquired. The protective put involves buying a put to hedge a stock already in the portfolio. If the put is bought at the same time as the stock, the strategy is called a married put. Synthetic call is simply a generic term for this combination.

Max Loss

The maximum loss is limited. The worst that can happen is for the stock to drop below the strike price. It does not matter how far below; the put caps the loss at that point. The strike becomes the 'floor' exit price at which the investor can liquidate the stock, regardless of how low the market price might fall. 

The amount of the total loss depends on the cost at which the stock was acquired. If the purchase price of the stock was the same as the strike price of the option, then the loss is limited to the premium paid for the put option. If the stock's purchase price was higher (lower), then the loss would be greater (smaller) by exactly that amount.

Max Gain

In theory, the potential gains on this strategy are unlimited. The best that can happen is for the stock price to rise to infinity.

If the stock rises sharply, it does not matter that the put expires worthless. A protective put is analogous to homeowner's insurance. The asset is the primary concern, and to file a claim means there has been a loss in the asset's value. A homeowner would prefer that the insured home remain intact, even though it means the insurance premiums are forfeited. Likewise, a protected put holder would rather see the stock do well than have to resort to the put's protection.

Profit/Loss

This strategy retains the stock's unlimited upside while capping potential losses for the life of the put option.

The profitability of the strategy should be viewed from the standpoint of a stockowner; rather than in terms of whether the put option turns a profit. The put is like insurance; it gives peace of mind, but it's preferable not to have to use it at all.

Consider a protective put versus a plain long stock position. The protective put buyer pays a premium, which lowers the net profit on the upside, compared to the unhedged stockowner. Returns will lag by the amount of the premium, no matter how high the stock might climb. But in return for the cost of the hedge, the put owner can precisely limit the downside exposure, whereas the regular stockowner risks the entire cost of the stock.

If the investor is reluctant to pay the cost of a put hedge yet can no longer accept the possibility of large losses on the stock, a different strategy might be called for.

(Source: OIC)

 

Upcoming Economic Reports

A preview of what may move the market this week 

 

 

Options Insider Radio Network 

Episodes from the network highlighting protective puts

Options Bootcamp 21: Playing Defense

 

Basic Training: Playing defense with options: it’s very important right now!

• Basic Defense: Protective Puts (full overview in Ep. 3)
• How do you hedge your position with protective puts?
• Intermediate Defense: Put Spreads and Ratio Put Spreads.
• Covered Calls - (full overview in Ep. 4) How do you generate income with a modest hedging impact?
• The Power of the Collar: combining the put and the call into a beast of an option. This is the favorite defensive strategy of most financial advisors who use options.
• The pros/cons of repeatedly doing zero cost collars.
• Volatility Defense: VIX Options/Futures. The myth of VIX's perfect inverse correlation- there are problems with relying on volatility as your only hedge, i.e. black swans, days when VIX outperforms, etc.
• The pros/cons of direct defense vs. indirect defense.

Mail Call: Hey recruits, what do you want to know?

• Question from Tina K. - When (if) should I consider volatility products as a hedge?
• Question from Mr_Zen - Can you explain the difference between iron condors and iron butterflies?
• Question from Alan O - What do the drill instructors think of the Minis so far? Are they worth exploring for basic options traders?

Options Boot Camp Episode 3: Buying Options

 

Basic Training - Buying Options 

• Buying Options, with special guest Joe Burgoyne from the Options Industry Council.
• Benefits & Downsides of buying options.
• The Greeks most relevant to novice options buyers.
• Bullish Example: Buying a call
• Bearish/Defensive Example: Buying a put.
• Common options buying mistakes: Buying OTM options vs ATM/ITM options, Intrinsic vs. Extrinsic value, loading up before earnings.

Roll Call: Mark and Dan sit down with this episode's guest Benny Joseph to discuss the Zecco mobile app. They cover a wide range of topics including:

• Can it execute options orders?
• Can you access the Greeks of your position via the mobile app?
• Can you execute complex, multi-leg spreads via the mobile app?
• What features of the Zecco mobile app set it apart from the rest of the pack?
• What has the feedback been since launching this new app?

Mail Call: Mark and Dan answer questions from Zecco's Facebook community including:

• From Arsalan: If I buy a call option and when it is time to exercise it, will that be done automatically (from the strike price or by the cost basis price, which would be the premium + strike?) or will I need to do something, as well as if I don't have the buying power to exercise the option, what happens, can I just have it buy and sell the stock right then and there and just have the profit.
• From Mike: Is Delta a measure of how much the option moves in relation to the stock? Example. A delta of 0.7 would mean if the stock moves 10%, the option would move 7%?

 

Advisors Option 32: Options & Concentrated Positions

 

Options 101: Managing concentrated positions

• What do you do if a client has a concentrated position?
• What if it’s a position in a company they manage/own?
• Options to the rescue!
• Protective puts
• Covered calls
• Collars
• The collar with a kicker

The Buzz: What’s happening in the options world?

• Wealth Advisor Summit
• Robo advisors
• Digital technology for advisor
• What is notable is what is missing: options, alternative investments, etc.
• SEC tries to hone in on derivatives exposure in funds

Advisors Option 23: Diversifying With Futures Options

 

Options 101: Options on Futures as a Diversification Tool

Futures options strategies. Covered call & Protective puts both require underlying futures positions - Most advisors looking for diversification typically want bullish exposure to the underlying. Stock/Futures replacement strategies. Vertical call spread. Spreads with wings.

The Buzz: Commodity Trading Advisors bounce back to post positive performance in August. Following a tough month for returns in July, all managed futures indices calculated by Newedge reported positive performance in August. The strong month means that all Newedge managed futures indices are also now in positive territory for 2014 YTD.

Advisors Option 21: Options for Protecting Profits

 

Options 101: Many clients are sitting on gains in their portfolios right now and are rightfully concerned about protecting them. Selling the assets with gains is a sure bet but eliminates future upside potential. This is an ideal use case for options.

Basic hedging strategies:

• Protective put: the basic defensive play.
• Put spread: ideal for protecting gains due to limited outlay.
• Collar: the holy grail of options positions for advisors.
• Ratio spreads/back spreads: ratios are tempting but can add risk to a portfolio. Back spreads may be more appropriate for some experienced.
• Hedging an individual asset is relatively straightforward: simply implement the hedging strategy in the product you want to protect.
• Hedging a broad portfolio is a little more difficult and requires determining the beta of the portfolio and the appropriate number of shares of the index product to hedge as result. Any tools or platform recommendations to assist with this process?

Listener Mail: Listener questions and comments

• Question from Tyler Madison: I'm studying to become a CFA in Virginia. Your program has been tremendously helpful in preparing me for any options components of the exam. It has also armed me with potential options strategies to use for my clients. Thank you for this great content. You could really charge for this. If I may, I'd like to ask a question about open interest. I see this mentioned quite frequently by options analysts. What impact does open interest play in the options market - does an option with high open interest behave differently than an option with low open interest? Is this something I should pay attention to when trading options for my clients or is this not important? Thanks again for all of your insight - Tyler.
• Question from J. Schaw, Ontario: Can the advisors options hosts recommend any good listed products that generate options income? I like the strategies you discuss on the show but simply don’t have time to manage all the strikes and such for my people. Available in Canada is obviously a big plus for me.

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Thursday:

Option Block LIVE at 12pm Central
This Week in Futures Options LIVE at 1:30 Central

Friday:

Volatility Views LIVE at 12pm Central

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