Options Sage submits:
Houses, cars, jewelry, that plasma TV from Best Buy…. they all have a commonality – insurance!
It seems no matter what you buy these days you can protect it from that “just in case” scenario. So, why not stocks? Can we protect them too from disaster? The answer is we sure can but in a much more sophisticated way then you can buy insurance on other products!
Let’s say, for example, you own a home in an earthquake zone and no earthquake occurs or in a region where flooding is frequent and no floods occur, can you approach your insurance company at the end of the year and request a refund on some of the premium spent to protect your home during the year? (If you can, let me know!). However, when we purchase insurance in the form of long put options on our stock positions we can often recapture some of that premium if the disaster we were concerned about doesn’t occur.
The challenge in purchasing stock insurance – as with any insurance product – is trying to figure out which type of insurance will best suit our needs. Let’s assume you are a highly conservative investor and you would never feel comfortable navigating the stock market without significant protection, you could purchase a long put option out far in time, perhaps a LEAPS put at-the-money.
Phil, as you know, is not one to own actual stocks when it can be avoided but he did promise to pick some and we will start this week with KMP, a pipeline company that pays a whopping 6.5% dividend! One drawback to options is you don’t get the dividend and, juicy though this one is, it’s no guarantee the stock will go up forever.
Rather than wait for a pullback on this one, we will buy the 100 shares of the stock for $5,050 as well as some insurance, in the form of the Jan ’09 $50 puts in the form of a single contract for $400. With the stock at $50.50 we are fairly well protected against any downside movement and the April dividend payment of (estimated) $83 will already pay back over 20% of the cost of our insurance.
Let’s assume a worst-case scenario for KMP; costs go out of control, there’s an option scandal, no one buys any oil or natural gas for a year and the stock plummets back to 2002 lows at $30 – admittedly this is a doomsday scenario but it’s helpful in explaining an extreme situation! What would your risk be in the trade where you held the stock all the way to $30 and maintained your long put in the form of insurance as the stock dropped? The answer is simply the cost of the long put plus $0.50! [i.e. the loss in the stock as it falls from $50.50 to $50 plus the cost of the long put à below $50 our long put starts protecting us plus the cost of that protection, $4.00 per share]Even though the stock dropped from $50 to $30 in our hypothetical example, the long put has ensured that we lose just $4 of that $20. The reason is once we purchase a long put option we buy the right to SELL stock at that strike price ($50) for a specific timeframe (2 years).
I can already hear the wheels turning for those of you who are familiar with Phil’s usual strategies: Because we own both the common stock and the leap, we can sell other options against both positions, generating two additional income streams while we wait for our dividends! Now you are thinking like traders…
As with all good trades, we need to set a goal when entering a trade, create an expected return profile and decide how much risk we are willing to endure.
We start by recognizing that our cost in the trade has increased by purchasing that long put option. When you initiate this trade (long stock + long put), you will require a stock increase of $4 (cost of long put) between now and Jan 16th, 2009 in order to break even. Given the company’s price performance over the past 2 years, this is an iffy proposition!
So we are playing this game with the expectation of minor appreciation, say 5%, with an eye towards collecting our 6.5% annual dividend. This makes our goal to do better than 11%, less the $4 or 4% per year we’ve allocated to protect our position. Anything we can do in between to exceed that goal is a logical decision!
Since we are unencumbered in both of our positions (they are independent of each other and require no margin) we are free to sell other contracts against them:
March $52.50s are 4% out of the money and can be sold for .35. While .35 might not sound sexy, if you do that 12 times a year it’s $4.20, an 8% boost to your return! Exact timing of an entry on this contract will be determined during the week, as Phil always likes to maximize his returns on the monthly sales…
June $45 puts sell for just .40 and, while this is a nice return on our protective put, it’s not enough to justify removing 75% of our downside protection should the stock fall to $30 for unforeseen reasons. So we will wait patiently on this one and let it do its primary job – protecting our income producer!
Another application of the long put is as a directional play on its own where we simply plan on taking advantage of a downtrend or expected downtrend in a stock and purchase much shorter term options. This is actually a much more common application of the long put instrument but requires better timing of the market than in the example above.
Example
Phil has written at length about his expectation for the oil market and one of the bellwethers, Exxon (XOM). In fact one of his longer-term plays is the XOM Jan 08 LEAP puts. In spite of the fundamentals, Phil knows well that sentiment can drive a stock anywhere in the short-term and regularly hedges against unexpected bullish rallies. We will see more of these hedges and spreads in future articles. For now, it would be a great idea to at least follow his longer term trades such as XOM LEAPS put options as a virtual trade in your own virtual portfolio. It’s FREE education, so why not follow along!
You will see Phil employ the long put regularly not only to speculate on bearish moves but also to hedge against bullish plays. These combination positions are quite easily understood once the individual options instruments are understood and we will build up to those butterflies and condors and backspreads in these educational articles over time.
For those members who can’t wait – please see Section 5 – “Advanced Strategies” in our Education section!
Yours truly,
Options Sage
