Online Options Trading Basics and Tips – Protective Puts

The number one rule of many successful investors is simple.

Don’t lose money.

In fact, Warren Buffet, perhaps the most successful investor of all time follows two important rules.

1. Never lose money
2. Never forget rule number one

Of course, on paper these rules are extremely simple, but in practice they are difficult to achieve.  Investors today must employ an active approach to monitoring their portfolio and should understand multiple investment strategies in order to maximize profit and minimize risk. One instrument that can help to accomplish these goals is stock option contracts. Although the risk of loss via options trading can be great and therefore is not recommended for inexperienced investors, when used properly options add an additional tool to one’s investing toolbox. Many brokers offer the ability to trade options online and executing a trade is relatively simple. Options are considered derivative instruments because their prices are derived from another asset class, the underlying stock. Option contracts are divided into two categories: calls and puts, and are used for three main functions:

1. To speculate on the directional movement of a specific stock price
2. To “hedge” or insure a current position against loss
3. To increase profit by utilizing leverage

Before utilizing options as an investment tool, an investor must choose an options strategy designed to fit his or her financial goals. Choosing the proper strategy requires a solid understanding of how options work. The remainder of this post will discuss how put options work, specifically how they can be used to hedge a position against dramatic loss, and thus help accomplish the elusive goals above.

If you’re new to options trading, consider becoming familiar with call options prior to reading the following section on puts.  For a review of how call options work see these posts:

How Do Stock Options Work? Call Options Explained

Long Calls

Put Options | Protective Puts

A put option contract grants the buyer of the contract the right to sell shares of the underlying security at a specific price, called the strike price, before a specific date, called the expiration date.  Usually, one put option is equal to 100 shares. This right is not imparted free of charge ,the buyer must pay the seller of the contract a fee called a premium.  The seller of the contract is then obligated to buy the underlying stock, at the strike price, if assigned. However, the put holder is never obligated to exercise his right to sell and can choose to allow the contract to expire.  Purchasing a put option contract is referred to as going long a put. Puts can be used to place a leveraged bet on a future price decrease for a particular stock or as a “hedge” to protect a current position from a dramatic fall in price.  During times of economic uncertainty, using protective puts can help protect gains from long-term buy and hold stock positions.

The following is an example of how purchasing a put option can “hedge” or act as an insurance policy on a current stock position.

Rumors that the popular iPhone will be sold at communications company Verizon (VZ) have caused a rally in the stock price of almost 22% in the last few months. Let’s assume an investor had purchased 100 shares of VZ on Aug 2^nd 2010 when it was trading at $29.56/share. Since this purchase the stock has rallied to $35.92, a 21.51% return.  This investor could sell his position and lock in this return, but by doing so he can no longer profit if the stock price continues to rise.  Also, he could hold his position but he risks diminishing or even losing his profit in the stock price falls lower. Alternatively, the investor could purchase a protective put option.  A protective put allows the purchaser of the option to sell the stock at the strike price, regardless of any major decline in share price, and thus acts as an insurance policy against dramatic loss. For this example the investor decides to purchase the Jul 16 2011 35 put option for $2.12.

Outcomes

1. At the market close on July 15^th 2011, (expiration is July 16 but the market and most brokers are closed on Saturdays) Verizon could be trading for $45/share. The rumors were true and the iPhone sold millions of units, creating an increase in revenue and therefore an increase in VZ market price. In this situation, the stock price is higher than the strike price and is therefore considered “out of the money” and the put contract expires worthless.  The entire premium is lost but the trader could sell his VZ position at a profit.  At this point he would have a net profit $1,329 (4500-2956-212).  The cost of the put has decrease the rate of return of this overall trade.
2. At the market close on July 15^th 2011, Verizon could be trading for $25/share.  In this scenario, the stock price is lower than the strike price of the contract and it is considered “in the money”.  The investor can exercise his right to sell his stock at the strike price of $35 even though the current market price of $25. Therefore, the put option has protected his VZ position against dramatic loss.  The net profit for this trade would be $332 (3500-2956-212). If the investor had not hedged his long stock position he would have a loss of $456.

In conclusion, stock options can be used in a variety of strategies that can allow an investor to profit in a market that moves in any direction.  Trading options online is not without risk as one’s entire initial investment can be lost.  However, intelligent investors understand how stock options work and when to implement specific strategies. Protective puts can be used to protect a current position in one’s investment portfolio by hedging against downside risk.  This insurance policy does have an associated cost and must be considered. Also, it should be noted that this example does not include commission fees that must be paid to the broker which can dramatically alter the rate of return.  Purchasing puts can also be used to speculate on the downward direction of a stock’s price; however this strategy is not discussed here.

For another example of how protective puts can minimize risk check out this post:

How Do Stock Options Work? Protective Puts Explained

Put options can also be sold as well as bought. For information on selling puts check out this post:

Options Investing: Writing Put Options to Generate Additional Income or Acquire Discounted Stock

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