Using Put options as insurance

[DennisWef]

I was watching this video on using Protective Puts to hedge a Long stock investment against a downturn in the stock. I thought this was brilliant (not having ever traded with Options before).

This leads to a couple of questions:

1. Wouldn't it always be wise to buy Puts on a stock trade that is fairly expensive, as most are? In other words, if I was going to buy 200 shares of IBM at a cost of $36,000, wouldn't it make sense to have a couple of Puts to insure against a downturn. (Like we had a month or two ago).

2. Why don't any large brokerage Financial Adviser's ever suggest this method? I could have saved a bundle in 2001 and 2008. Thank you Merrill Lynch and Wachovia.

[DennisEn]

Puts cost money. Depending on your time frame (say 6 months of insurance), it can easily cost a k for just a hundred shares of stock to insure (though it depends on the stock, of course).

It sounds great in practice, but you must account for the reduction in gains, as well. Gains are never certain, and they must still be sufficient to offset the cost of the puts. The best a put can do with this strategy is preserve value.

If you see a decline coming, it is a very useful instrument. Otherwise, be sure you find it worth the cost.

Another strategy to look into is the Covered Call. Here, you receive the premium and a bit of downside protection. If you combine both the protective put and the covered call, you get a Collar. Maybe you would prefer this strategy as the short call may offset the cost of the put. This strategy must still be applied with discretion, however.

Look into it, bud. The best book on options is, imo, Options as a Strategic Investment by McMillan. It tells you all about e'm.

[DelorasHei]

Well, do you know about seasonality? The market typically trends up between late Oct to late April, then tends to downtrend from May to late fall. Autumn is especially bad sometimes. Sept and Oct have recorded some of the worst stock periods, for example (1929, 1987, 2008... All in sept/oct).

Keep in mind these are generalities. Everyone's been expecting a Santa rally this year, but it's yet to happen. You can perhaps sort of time your insurance purchase around then for maximum effect. Say maybe an 8 month put starting in May? (That sounds hella expensive, though... Be sure to thoroughly research this first)

[debxbem]

Yes, I understand the normal ups and downs, and seasonality. But my suggestion is that the normal trends may be a thing of the past now. At least for the next year or two. If the effect of the restructuring of the global economy is as I suspect it might be, this may be a new typical with higher and lower market swings than we've seen in our lifetime and much higher volatility than we are used to, as a norm. This is why I steer my thinking toward better hedging. I certainly expect more panic reactions in the market as time goes by, and I think it stinks waiting to recover from these types of market failings.

(Bear in mind, that these are only for longer term trades; not the day variety that I also dabble in.)

[Donaldinio]

here are lots of different strategies at play here. Which you choose depends on your personality (e.g. risk tolerance) and your belief in what your stock will do.

If you just do long stock with long puts, that is often referred to as a "Married Put". One common strategy is to always start a trade as a married put, but reduce the amount of put protection if the stock goes into an uptrend. Then when the uptrend peters out, add in some put protection.

You can sell a call option above the stock and use that money to help pay for the Put. But that call will limit your profits in an uptrend, so use them wisely.

You are right, in these volatile times, establishing collar trades can help you sleep at night. Whenever I travel on business and want to dedicate my focus to work instead of trading, I always collar all my stock.

Send me a PM, and I'll send you a white paper on Collars. Might be helpful.