WEEKLY SPOTLIGHT

Don Kaufman

How to Enhance Your Returns and Minimize Your Risk with Options

By Don Kaufman, TheoTrade.com


Hedging Your Long Term Portfolio with Put Options

Would you drive a car without insurance? Would you even think of owning a home without insurance? Most people buy insurance to protect their investments from loss. One never wants to collect on a policy, but buying insurance is prudent, regardless. Options, like insurance policies, can be used to limit risk.

Professionals believe that the only way one can safely be in the market for the long haul is by being hedged. Put options can be used as an insurance policy to protect stock or mutual fund holdings. As a good rule-of-thumb, when you buy stock or mutual funds, you should buy puts. Buying puts to hedge a stock position is referred to by the professionals as “married puts.” You will learn at TheoTrade how to hedge a mutual fund by using index options. A mutual fund is a basket of stocks, as is an index. You should buy enough puts to cover your long stock position. (Remember, one put contract gives the holder the right to sell 100 shares of the underlying stock, at the strike price, before the expiration date.) By purchasing puts, you minimize the potential loss on a stock or mutual fund, should it decline in price.

For Example: You buy or own 1,000 shares of XYZ at $31 and ten 30 strike puts, one month from expiration, at $1. By purchasing the put, you have increased your investment in XYZ to $32. (TheoTrade philosophy: If the stock is not worth $32 with protection, it is not worth paying $31 without. You are buying XYZ because you think the stock is going up. If you don’t believe the stock or mutual fund will go up by at least the cost of the put in the time remaining until expiration, it’s not worth owning!)

Buying puts for protection is obviously a bullish strategy. If you thought a stock was going down, why own it. However, you don’t mind paying insurance for something you feel will continue to go up in value. Therefore, it is important to understand that buying married puts is not a cure for poor performing stocks. If you own a stock that is not going up, why do you continue to own it? Sell it, and buy one you are confident will go up, along with a married put, in case you’re wrong! With married puts, you should be confident that the stock will increase in price and also be willing to give up a little upside profit to offset your downside risk protection. By purchasing puts, you set the maximum loss on the stock at the put strike price, less the cost of the put. In our example, you are guaranteed $29 for the stock (the put strike of 30, less the $1 premium paid for the put) even if it goes to zero prior to expiration.

The advantage of buying puts over stop-loss orders:

Stop loss orders are poor protection against sudden downturns in a stock. Bad news, poor earnings, political problems, and many other factors can cause a stock to gap down. In our example, should the stock gap down from 31 to 20, a 30 stop loss order would sell the stock near 20 not at 30 since the stock never hit a price between 30 and 20. If you have a 30 stop order once the stock hits 30 or below, the stock is immediately sold at the market price. If you had a “stop limit order” at 30, you wouldn’t be sold until the stock goes back to 30. However, the stock could continue to drop. Stop and stop limit orders, therefore, provide very little protection. But, if you own the 30 strike put, you have the right to sell the stock at 30 any time prior to the option’s expiration. A stop-loss order can also force an untimely sale. When a stock price reaches the stop, it is sold automatically; thereby eliminating the chance of participating in upward movements should the stock turn around. Owning the puts allows the holder to ride out these downturns.

The options of the married-put holder: Should your stock decline in price, you have two options as a married-put holder:

  1. You can exercise your right to sell the stock at the put strike price.
  2. You can sell the put option and keep the stock and then re-hedge the position with another put. You will then own the stock at the current price, but the sale of the put option will give you the difference between the put strike price and the current price of the stock, plus any remaining time value in the put. The following table will show you the value of the put option at expiration based on various stock prices. Notice that if you keep the stock you will own the stock at the current price, plus have cash equal to the intrinsic value of the option. Adding the two together, your net loss in this example will never be more than $2, no matter how low the stock goes.

Profit or Loss on XYZ stock bought for $31 with 30 strike put purchased for $1 for a total investment of $32.

Maximum Loss: The difference between the price you paid for the stock, less the strike price of the put, plus the cost of the put and commission.

When you buy a put, you are buying the right to sell the stock at the strike price, less the cost of the put. If your stock declines, you can sell the put and buy a lower-strike-price put for the next month. If the stock moves up, you can lock-in profits by purchasing a higher strike put.

At the TheoTrade you will learn specific criteria on what strike price put and expiration month to purchase to properly hedge your stocks or mutual funds. Then you will learn specific criteria for re-hedging the position to lock in profits should the stock or mutual fund increase in price or minimize losses should the stock or mutual fund drop in price. TheoTrade emphasizes “Trade Criteria” and is worth the investment in our course materials.

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ABOUT THE AUTHOR

Don Kaufman

Don is one of the industry's leading financial strategists and educational authorities with 18 years of financial industry experience. Prior to co-founding TheoTrade, Mr. Kaufman spent 6 years at TD Ameritrade as Director of the Trader Group. At TD Ameritrade Mr. Kaufman handled thinkorswim® content and client education which included the design, build, and execution of what has become the industry standard in financial education. He started his career at thinkorswim® in 2000 (acquired by TD Ameritrade in 2009), where he served as chief derivatives instructor, helping the firm progress into the industry leader in retail options trading and investor education services.