PROTECTIVE PUTS This is a very common strategy, but for the most part, as good as it is, it is not as good as most people think. Review the call option section, then reverse the knowledge there—when stocks go up, call options go up—when stocks go down, put options go up in value, hopefully.
An option gives the owner the right to buy or sell stock at a set price on or before an expiration date. Options have an expiration date, therefore they carry an extra element in the risk category.
Let’s explore how a put works. The word is appropriate word, because that is exactly what you are purchasing the right to do. One point first: This option gives you the right but not the obligation to perform, or exercise the option. Most people do not play options to actually buy or sell the stock. They buy the option, hoping the option will grow in value and then sell it for a profit.
Like all options, the deck is really stacked against you. I want to say that up front. We’ll go through the put examples, and then go through the ½ of 1 chance in 3 of making money. Most people lose at options.
A PUT: You literally have the right to put (or sell) this stock (whatever stock you chose) to someone (whom you do not know) at a set price (pre-determined by you) on or before a date certain (which you choose). This date is called the expiration date.
A STRAIGHT PUT PLAY
In our first example and explanation we’ll do a pure option trade. We don’t own the underlying stock. We want to get in, get out and make a short-term profit.
You like a stock. It’s at $16 and you don’t think the price can be sustained. It had great news (earnings) and the stock shot up about 50%. You check out the put prices.
The $16 puts are $2.10.
The $15 puts are $1.60.
The $14 puts are 90¢.
The cheaper the strike price the cheaper the put premium. Options are in 100 share increments, called contracts. Let’s use the $15 put. One contact would cost $160 plus commissions. We’ll take that as a given, the commission thing, and not mention it again, but you have to in your calculations.
What do you own? The right to put this stock to someone at $15. If the stock stays at $16 or goes higher the value of your put option goes down in price. You could easily lose all or part of your money. 10 contracts would cost $1,600. Think of this, $1.600 lets you sell 1,000 shares of this stock of this stock at $15. Wow, that could be huge. If this stock goes to $13, that price is $3 in-the-money. $13 up to $16. You option would have to be worth the in-the-money portion, or $3, plus any time value still in the put premium. This $13 price could put the option at $3.50. If you were to sell your option for $3.50, having spent $1.60 to purchase it, your profit would be $2.90. That’s $290 or $2,900, depending on how many contracts you own.
Why doesn’t everyone do this? Well, we’ll get to that. Remember, I already wrote that most people lose money trading straight options. For example, what if the stock goes down, exactly as you planned, but it only goes down, say $1, to $15. If the stock did this tomorrow, and a huge move like $1 in a day, your put option on the next day could easily be $1.90, maybe a little more. Wow, in one day your 10 contracts, your $1,600, could be $1,900—a $300 profit. Let’s have a party/
But what if the stock goes down slowly? It goes down, like you thought, but not that much. Time goes away quickly. The “fluff” is sucked out of the put option. You could easily be left holding the bag. A loser.
I’ll repeat, the stock has to go down and go down quickly or you lose. Now, having said that, let me also state, that stocks seem to go down more quickly than they go up. They’re fighting gravity, not using it. I don’t play a lot of puts. My reason is personal to me, and I’m not asking you to buy into it. You will make more money with puts than I do. Here’s my problem. When I buy a put, I’m hoping for something negative, and I don’t like the feeling. “Oh, if that plane crashes, my put will go up and I’LL GET RICH.” “If only that restaurant chain would give some customer a case of Ebola, I’ll be able to pay for my vacation.” See? I just don’t enjoy that way of thinking. My positive nature serves me well in almost all other cases.
I’ll repeat the chances of making money. A stock (and a put upon which the price is based) will go up, down, or sideways. In our example, if the stock goes up, you lose. If the stock stays the same, you lose. If the stock goes down, but goes down slowly and only down slightly, you lose.
THE STOCK HAS TO GO DOWN A LOT, AND QUICKLY FOR YOU TO MAKE MONEY
You can use puts for strictly cash flow purposes. These are usually one to three day trades. I like them for about only one thing: Rolling The Dow. I will buy a put when I think the whole market will go down. I post these on a subscription site, called TRAIL, sponsored by WIN.
Straight puts are treated like call options for tax purposes. See you tax professional for advice.
Put can be used to protect the downside movement of a stock. An example. You like Disney. It’s around $110. You own the stock and hope it will go up, but just in case it goes down, you buy a put, say at the $105 strike price. The put option costs $1.60. This is called a protective put. It is a common use of put options.
Think of this. If the stock drops to $100 or even $95, you could own a put that goes up in value. It works like the straight put—it goes up in value as the stock goes down in price.
Here’s my problem with the way this type of this trade is that it makes it sound like it works all of the time, and that no matter which way the stock moves, you’ll make money. This is wrong, at least, incomplete.
Your stock may back off $3, and that $2 price you paid for the put, may only go up to $2.50. You may have paid for protection, but it wasn’t enough. The stock is down $3, and you made only 50¢ profit on the put.
Does a protective put help? Yes, somewhat. Just don’t expect it to solve all of the problems. One last mention of taxes. Protective puts create what is called a married position. The ramifications of this is that while you have a put in place against a stock you own, the time period moving along to make your stock qualify for long-term capital gains, is halted. Again, check with your tax professional, as these rules and regulations are always changing.