Buying Protective Puts to Reduce Risk

Uploaded by tradeking on 21.10.2010

bjbjD SEQ CHAPTER \h \r 1 Introduction Hello, I m Brian Overby, Senior Options Analyst at
TradeKing. TradeKing is an online stock and options broker. We re known for our award-v4winning
customer service, cutting-edge tools, and our competitive pricing re only $4.95 a trade.
We also have a very active Trader Network, which is a community of traders of all levels
of experience where you can see real trades from our members and their performance, and
you can share your trade ideas and discuss what s happening in the marketplace. If you
d like to learn more, please check us out at Protective Puts Today we
re actually going to talk about option trading, we re going to talk about buying protective
puts. Now, if I look at options, a lot of times people think of them just as, oh gee,
I want to learn how to get rich speculating on options, but options can also be used to
help reduce risk. As a matter of fact, it s one of the first things that options were
intended to do, is to be used to decrease risk as opposed to increase risk. Now we re
going to talk about one of those strategies here today, about buying protective puts.
Before we do that, we would like to go out and look at what an option contract does,
so let s talk a little bit about the terms and conditions of the contract. If you buy
an option, you have a right. That right is to buy or sell stock at a specific price,
over a specific period of time. That right then also obligates the seller to take the
other side if and when the option is exercised by the buyer. But here s the bottom line:
if you buy options, you pay cash; for that cash you get a right. If you sell options,
you receive cash; for that cash you take on an obligation. On this slide we actually have
the four basic things that you can do with an option, but what we re going to focus on
is buying put options. If I buy a put, that gives me the right to sell an underlying asset
at a specific price over a specific time period. So, let s look at buying a protective put,
and then we ll talk about the nuances of buying a stock and buying a put with it, as opposed
to just owning a stock outright. So, XYZ stock s at $65, we go out and in one transaction,
just to make life simple, we re going to buy 100 XYZ shares at $65, and we re also going
to go out and buy one XYZ $62.50 put that goes out 46 days for the time. Now, once I
buy that remember, if I m a buyer of options I get a right, but I ve got to pay for that
right, that right is going to cost me $1.50. And so that increases my cost basis, the overall
cost basis, but it also reduces my risk. So the total net debit of this trade is $66.50;
the commission on the trade is around $12.00 on the TradeKing website. Now let s take it
and fast-forward to expiration, and let s look 46 days from now and let s evaluate the
risk. Now first of all, you ve got to think about the difference between where the stock
price is at and where that strike is. You can almost think of that as a deductible
, in that I m taking on those first 2.5 points of risk. If the stock goes below $62.50, I
can take it at, let s say $55, and put it to somebody at $62.50, but I lost that first
$2.50 worth of value from $65 down to $62.50. Now, remember that if you re buying a put,
you have a cost. So now that cost in this instance is $1.50, so the overall loss, if
I buy this put, the potential loss over the next 46 days is around 6%; $1.50 plus that
deductible of $2.50, if you will, that s my overall loss. Now on the upside, if I do this
I really hope that the stock continues on up above $65 at expiration. I really need
it to go to about $66.50, and at that point, that s where the strike price is, plus the
premium paid, then I m happy that I did this trade. Because if it continues on up, I stayed
in the stock, I didn t get out, I didn t leave the trade because I was nervous about something.
I stayed in, and I have all the upside potential now. My break-even on this total stock position
is the $66.50. Anywhere below that, 46 days at expiration, you re going to have losses
that will occur on that trade. Be aware of that. But, if I actually look at the graph
of this trade, once again we have the x axis which is the stock price at expiration, and
we have the y axis, the up and down axis, which is the profit and loss of the entire
position. If I buy the stock outright at $65, my break-even is right where it crosses that
x axis at $65. Substantial upside, but also substantial downside. If I go out and I buy
the protective put, on the downside I ve limited it, I have the right to take the stock, put
it to people at $62.50, I can t lose any more. On the upside, though, I still have substantial
upside, just like if I had owned stock, all the way up until that expiration date. But
the big news is, is the break-even increases. If I reduce risk on the downside, I m usually
going to have an increased cost, and that s the case here. The break-even is going to
now be $66.50, as opposed to being $65 on that position. All right, so now things to
think about: first of all: how can I enter this trade? Can it be done all as one trade?
And yeah, that s the way we set up our example, is that you are buying stock and buying the
put all at once. That is actually called a married put, and you can actually enter that
entire trade into the marketplace all as one trade; the commission s going to be around
$11, $12 on the TradeKing platform. And don t forget, you have multiple legs so you re
going to have those multiple commissions because of this. But I can enter it that way if I
want. Now, the next bullet point that we re talking about is: can I buy the stocks first
and then buy the put later? That s by far the most popular scenario. Usually when I
first buy the stock, why am I buying it? Because I think it s going to go up, right? I m not
nervous about the downside when I first buy it. But maybe I bought the stock and it s
increased in price, or I ve held it for a while and there s a major news event, and
so then I go out after the fact and I buy the put option. That happens quite often.
Now, has anybody actually for this scenario, I always like to walk through a little scenario
have you ever bought at stock at $50, and before you know it was up at $70 and you thought
to yourself: wow, I m a great stock picker? But if it s made that big of a move in such
a short period of time, I m definitely going to stay in it because it s obviously going
to $100. And before you know it, it comes back down and now it s trading at $65 and
you say to yourself: okay, if it only gets back up to $70, then I promise I ll sell.
And then before you know it, it s back to $60 and you say: okay, $65 wasn t bad; if
it gets to $65 I m out. And then before you know it, it s all the way back to where you
bought it at, and you sell it and you say: whew, I didn t lose anything. Well, think
about that type of scenario, and think about using the protective put options. The stock
reaches $70, what do you say to yourself? If I buy that put, and I spend a few dollars
on that put, I can maybe go out a month or two in time and then actually secure some
of that downside, make sure that I know that I m going to at least get a little bit of
that profit that happened. This is when protective put buying is very attractive to people that
have long underlying stock positions. Another thing to think about: you re in control because
you bought this put. So, if you do buy it and the market actually goes down, well, in
that scenario you can actually go on out and just sell the put if you would like, you don
t have to exercise it. You can sell the put when the market goes down. Hopefully the value
of the put would increase in price, and in that scenario, if we went through it, then
you should be able to make a little bit of profit on the put to help offset some of the
loss that you might have had on the stock. Now, most of the time it s not one-to-one,
because first of all you have a deductible in there and everything else that s involved.
But, bottom line is, you can help offset some of that risk at that downside move. Also another
thing to think about: if you re trying to insure a stock that is very volatile, let
s say it s a volatile stock, with a news event, the cost is going to be more expensive. That
news and that fluctuation that that stock has done previously usually adds to the value,
because it costs more to hedge that position. And it makes sense overall more risk means
more cost. Also, think about this: if it is a more expensive underlying, if the stock
is $500 versus $10, well, it s going to cost you more to hedge your risk on a $500 underlying
than it will on a $10. Why? Well, a $10 can only go to zero; a $500 can go from $500 all
the way down to zero, so there s limited and known risk on a lower-priced stock, much more
limited than on a higher-priced stock. Closing If you d like to learn more about these topics,
please check out our Learning Center on Also you can find answers to your questions
inside our Trader Network, where many traders like to share tips and talk about where the
marketplace is going to next. ve also authored The Options Playbook, which available for
purchase on, and you can actually view it online for free at
If you d like to hear more about my thoughts and tips, check out my blog on our Trader
Network just look for the Options Guy. hjH hjH urn:schemas-microsoft-com:office:smarttags
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