Put Buying Strategies

There are three reasons to buy puts. The first is purely speculative: the hope of realizing a profit in a short period of time, with relatively small risk exposure. This leveraged approach is appealing but contains higher risks along with the potential for short-term profits. The second reason to buy puts is as an alternative to short selling of stock. And third, you may buy puts to provide yourself with a form of insurance against price declines in a stock long position.

Strategy 1: Gaining Leverage

There is value in the leverage gained using the put.
With a limited amount of capital, the potential for profits is greater for put buyers than through stock short selling, and with considerably less risk.

Example

Safer than Shorting Stock: A stock currently is valued at $60 per share. If you sell short 100 shares and the stock drops five points, you can close the position and take a profit of $500. However, rather than selling short, you could buy 12 puts at 5, for a total investment of $6,000. A five-point drop in this case would produce a profit of $6,000, a 100 percent gain (assuming no change in time value). So by investing the same amount in puts, you could earn a 100 percent profit, compared to an 8.3 percent profit through short selling.

This example demonstrates the value in leverage, but the risk element for each strategy is not comparable. The short seller faces risks not experienced by the put buyer and has to put up collateral and pay interest; in comparison, the put buyer has to fight against time. Risking $6,000 by buying puts is highly speculative and, while short selling is risky as well, the two strategies have vastly different attributes. The greater profit potential through leverage in buying puts is accompanied by equally higher risk of loss. However, even without a large sum of capital to speculate with, you can still use leverage to your advantage. This comparative analysis shows the flaw in analyzing two dissimilar strategies. Because the risk attributes are so different for each, it is not accurate to draw conclusions based only on potential returns.

Example

Comparing Apples to Oranges: You buy a LEAPS put for 5 with a striking price of 60 and 18 months until expiration. The stock currently is selling at $60 per share; your option is at the money. Aware of the potential profit or loss in your strategy, your decision to buy puts was preferable over selling short the stock. The luxury of 18 months in the LEAPS put is preferable over remaining exposed to short selling of stock. As shown in Figure, a drop of five points in the stock's market value would produce a $500 gain with either strategy (assuming no change in time value premium).

[caption id="attachment_12473" align="aligncenter" width="380"]Rates of return: selling short versus buying puts. Rates of return: selling short versus buying puts.[/caption]

The short seller, like the put buyer, has a time problem. The short seller has to place collateral on deposit equal to a part of the borrowed stock's value, and pay interest on the borrowed amount. Thus, the more time the short position is left open, the higher the interest cost -- and the more decline in the stock's value the short seller requires to make a profit. While the put buyer is concerned with diminishing time value, the short seller pays interest, which erodes future profits, if they ever materialize, or which increases losses.

A decline of five points in the preceding example produces an 8.1 percent profit for the short seller and a 100 percent profit for the put buyer. Compare the risks with this yield difference in mind. Short selling risks are unlimited in the sense that a stock's value could rise indefinitely, creating ever-increasing losses. The put buyer's risk is limited to the $500 investment. A drop of $1 per share in the stock's value creates a 1.6 percent profit for the short seller, and a 20 percent profit for the put buyer.

Potential losses can be compared between strategies as one form of risk evaluation. When a short seller's stock rises in value, the loss could be substantial. It combines market losses with continuing interest expense and tied-up collateral (creating a lost opportunity). The put buyer's losses can never exceed the premium cost of the put.

Strategy 2: Limiting Risks

It is possible to double your money in a very short period of time by speculating in puts. Leverage increases even a modest investment's overall potential (and risk). Risks increase through leverage due to the potential for loss. Like all forms of investing or speculating, greater opportunity also means great risk.

Example

Profits Becoming Unlikely: You recently bought a put for 4. However, expiration date is coming up soon and the stock's market value has risen above striking price. When the put expires, you face the prospect of losing the entire $400 premium. Time has worked against you. Knowing that the stock's market value might eventually fall below striking price, but not necessarily before expiration, you realize it is unlikely that you will be able to earn a profit.

Risks are lower for puts in comparison to short selling. A short seller in a loss position is required to pay the difference between short-sold price and current market value if the stock has risen in value, not to mention the interest cost. The limited risk of buying puts is a considerable advantage.

Example

Big Problems or Small: You sold short 200 shares of stock with market value of $45 per share; you were required to borrow $9,000 worth of stock, put up a portion as collateral, and pay interest to the brokerage company. The stock later rose to $52 per share and you sold. Your loss on the stock was $1,400 plus interest expense. If you had bought puts instead, the maximum loss would have been limited to the premium paid for the two puts. The fear of further stock price increases that would concern you as a short seller would be a minimal problem for you as a put buyer.

The advantage enjoyed by the put buyer typifies the long position over the short position. Losses are invariably limited in this situation. Although both strategies have the identical goal, risks make the long and short positions much different.

Strategy 3: Hedging a Long Position

Put buying is not always merely speculative. You can also buy one put for every 100 shares of the underlying stock owned, to protect yourself against the risk of falling prices. Just as calls can be used to insure against the risk of rising prices in a short sale position, puts can serve the same purpose, protecting against price declines when you are long in shares of stock. When a put is used in this manner, it is called a married put, since it is tied directly to the underlying stock.

This strategy is also one form of a synthetic position. The use of a long put with long stock creates a synthetic call. (When you use a long call to protect your position with short stock, it is called a synthetic put.) The risk of declining market value is a constant concern for every investor. If you buy stock and its value falls, a common reaction is to sell in the fear that the decline will continue. In spite of advice to the contrary, you may have sold low and bought high. It is human nature. It requires a cooler head to calmly wait out a decline and rebound, which could take months, even years. Special tax rules apply to married puts so, in calculating the cost and benefit to this strategy, you also need to evaluate the tax status for your stock. Check Risk and Taxes: Rules of the Game for more tax information on married puts.

The married put is a form of insurance protection. This strategy makes sense, whether you end up selling the appreciated put or exercising it. In the event of a decline in the stock's value, you have the right to exercise and sell the stock at the striking price. However, if you believe the stock remains a sound investment, it is preferable to offset losses by selling the put at a profit. When you exercise a put, that action is referred to as put to seller.

Example

A Profitable Dilemma: You own 100 shares of stock that you purchased for $57 per share. This stock tends to be volatile, meaning the potential for short-term gain or loss is significant. To protect yourself against possible losses, you buy a put on the underlying stock. It costs 1 and has a striking price of 50. Two months later, the stock's market value falls to $36 per share and the put is near expiration. The put has a premium value of 14.

In this situation, you have two choices:
  1. Sell the put and take the $1,300 profit. Your adjusted cost was $58 per share (purchase price of $5,700 plus $100 for the put). Your net cost per share is $44 ($5,700 less $1,300 profit on the put). Your basis now is eight points above current market value. By selling the put, you have the advantage of continuing to own the stock. If its market value rebounds to a level above $44 per share, you will realize a profit. Without the put, your basis would be 21 points above current market value. Selling the put eliminates a large portion of the loss.
  2. Exercise the put and sell the stock for $50 per share. In this alternative, you sell at 8 points below your basis. You lose $100 paid for the put, plus seven points in the stock.

Regardless of the choice taken in these circumstances, you end up with a smaller loss by owning the married put than you would have just owning the stock. The put either cuts the loss by offsetting the stock's market value decline, or enables you to get rid of the depreciated stock at higher than market value. You have a loss either way, but not as much of a loss as you would have had without buying the put.

The married put in this application provides you with downside protection, which reduces potential profits because you have to pay a premium to buy the insurance. If you intend to own shares of stock for the long term, puts will have to be replaced upon expiration, so that the cost is repetitive. However, as a long-term investor, you are not normally concerned with short-term price change, so the strategy is best employed only when you believe your shares currently are overpriced, given the rate of price change and current market conditions. In this situation, using puts for insurance is speculative but may remain a prudent choice.

In the event the stock's market price rises, your potential losses are frozen at the level of the put's premium and no more. This occurs because as intrinsic value in the put declines, it is offset by a rise in the stock's market value. Whether you end up selling the put or exercising, downside protection establishes an acceptable level of loss in the form of insurance, and fixes that loss at the striking price of the put, at least for the duration of the put's life. This strategy is appropriate even when, as a long-term investor, you expect instability in the market in the short term.

Example

Damage Assessment: You recently bought 100 shares of stock at $60 per share. At the same time, you bought a put with a striking price of 60, paying 3. Your total investment is $6,300. Before making your purchase, you analyzed the potential profit and loss and concluded that your losses would probably not exceed 4.8 percent ($300 paid for the put, divided by $6,300, the total invested). You also concluded that an increase in the stock's market value of 3 points or less would not represent a profit at all, due to the investment in the put. So profits will not begin to accumulate until the stock's market value exceeds $63 per share.

A summary of the insurance strategy is shown in Figure. Note that regardless of the severity of decline in the stock's market value, the loss can never exceed 4.8 percent of the total amount invested (the cost of the put). That is because for every point of decline in the stock's market value, the put increases one point in intrinsic value. This status continues until the put expires.

The insurance strategy is also a powerful tool when you plan to sell stock within the next three years, and you are concerned about the potential for losses by that deadline. Insurance protects your value and ensures that, even if the stock's value declines dramatically, you will not lose by continuing to own the stock.

[caption id="attachment_12474" align="aligncenter" width="403"]Downside protection: buying shares and buying puts. Downside protection: buying shares and buying puts.[/caption]


Example

A Wise Financial Planning Move: Several years ago you invested in 1,000 shares of stock and it has appreciated consistently over the years. You are planning to sell the stock in two years and use the funds as a down payment on a home. You don't want to sell the stock until it is needed, for several reasons. You will be taxed on profits in the year sold, so you want to defer that until the latest possible moment. In addition, you would prefer to continue earning dividends and, potentially, additional profits in the stock. But you also know the stock's value could fall. Even a temporary decline would be serious because you will need those funds at a specific date in the future. The solution: Buy 10 puts to insure the value at the striking price. Select puts with expiration dates at or beyond your target date. This reduces your stock's value by the cost of the puts; but it also ensures that any in-the-money declines in the stock's price will be offset by gains in the puts' value.

In this case, the decision to use puts is not merely speculative; it is necessary to insure the stock's market value. A decline might be reversed within 6 to 12 months, but that could create a hardship if you have a specific date in mind to buy a house. The use of puts as insurance can be applied in many ways to protect capital invested in stocks. Even the best stocks can experience a price decline in cyclical markets. When you cannot afford even a temporary decline, puts can be used to lock in a striking price value.

Strategy 4: Pure speculation

Just as call buyers speculate on a stock's price rising, put buyers accomplish the same result with puts. However, put buyers are hoping that the underlying stock's price will move downward.

The rules for comparison between intrinsic, extrinsic, and time value are identical for puts and for calls, but with underlying price movement taking place in the opposite direction. So the more a stock's price falls, the higher the premium value in the put.

Market sentiment plays a big role in determining the level of extrinsic value, of course. If the perception about a company is that its future is bleak, put value is likely to hold greater extrinsic value, notably for puts with a long duration remaining until expiration. However, if the optimistic view prevails and the perception is that the stock price will move upward, then put extrinsic values are likely to decline.

In selecting the best puts for speculation, several criteria should be in place, including:
  1. The put's striking price should be close to the current value of the stock.

    Example

    Putting the Matter to Rest: You have been watching a stock rise over the past month on what you consider overly optimistic outlooks for the company's future. This includes a rumor that the company is a takeover candidate, which you do not believe. The rise in price has recently stalled and you expect the price to fall in coming weeks. You pick a put and buy it. The strike is slightly lower than current market value, which means the premium cost is quite low. You anticipate a fast change in the stock's price, so you are less concerned with time value decline that you normally would be; if the stock's price falls as you expect, the long put could become profitable very quickly.

  2. Time to expiration has to be adequate for the stock to have time to make a strong downward move. This is a difficult judgment call.
  3. As little extrinsic value as possible should reside in the put's premium. This enables the put's premium to be highly reactive to downward movement in the stock's price. Otherwise, increases in intrinsic value will be offset by a decline in previously inflated extrinsic value, making it difficult to realize profits from put buying.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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