Protective Puts as a Form of Insurance
As an investor, you are familiar with the concept of insurance: your house, its contents, your car, and other valuable assets are insured. But what about your investments? Many investors do not insure their investments because they do not know it can be done. Put options, when used properly, are nothing more than insurance on individual stocks. See the box below for a review of put option basics.
You own 300 shares of PQR stock (currently at $41) and are worried about its short-term prospect. You are thinking of selling your shares, but worried that if you do so, PQR will rally, leaving you behind. How can you limit your downside risk and maintain some profit potential? Purchase three PQR April 40 puts at $2.50. If PQR rallies, you still own the shares and will see your gains accrue; your puts will become worthless, just as your fire insurance becomes worthless at the end of its term if your house has not burned down. If disaster strikes and PQR heads south, you can exercise your puts, selling your shares at $40, effectively limiting your total risk to $3.50 (the $1 drop from $41 to your selling price of $40, plus the $2.50 cost of insurance).
At What Cost?
The cost of insuring a stock varies widely. But here are some guidelines:
1) The longer the term, the more expensive the insurance. This is close to self-evident: if you purchase a 4-month put, it will cost you more than a 2-month put.
2) The higher the deductible, the lower the cost. Assume the stock you want to insure is trading at $61. You want to purchase a 3-month put and have the following choices: a 60 strike at $2.90 or a 50 strike at $0.30. The 60 put has a very low deductible: its protection kicks in as soon as the stock drops below $60, $1 under the current price. The 50 put only offers protection if the stock drops by more than $11 – it's a high-deductible option, with a correspondingly low cost.
3) The higher the stock's risk, the higher the cost of insurance. Think of insuring the following two drivers: an 18-year-old male with a new driver's licence and a 45-year-old man with no accidents during the last 20 years. Now think of buying puts on these two stocks: Advanced BioGizmo, a start-up firm with little or no sales but possibly some gangbuster products in the pipeline, and SteadyGrowth Consumer Products, a well-established maker of familiar household items that has weathered numerous recessions. Just as it will cost more to insure the young driver, it will cost more to insure the more volatile of the two stocks.
When to Insure
You may like the idea of insuring your stocks so much that you decide to insure all of your stocks on a continuous basis. This may not be such a good idea. Insuring stocks is a relatively expensive proposition – verify the cost of buying a 3-month put on your favorite stock. In fact, for a lot of stocks, in the long run, the cost would nullify most of the gains produced by the stock's appreciation.
So what is a prudent investor to do? Buy insurance when you perceive there is a relatively high risk that the stocks you own may be heading for a correction. Unlike other forms of insurance, you can pick and choose both the amount of coverage you purchase, and when you do so.
Put Options: A Review of the Basics
The buyer of a put obtains the right (but not the obligation) to sell 100 shares of the underlying stock at a fixed price (the strike or exercise price) for a limited period of time (until the option's expiry date). Example: if you purchase four of the XYZ September 50 puts, you have the right to sell 400 shares of XYZ at $50 up to and including the third Friday in September. You can sell these shares at $50 by exercising your option, and you have the right to exercise your option on any business day from the purchase date up until the expiry date. To obtain this right, you have to pay the market price of the puts, the options' premium.