This is a rebroadcast of OICs webinar panel. In this deep dive discussion, Frank Fahey (representing...
How to Trade a Married Put Strategy
09/09/2009 12:01 am EST
What Is a Married Put?
In many of my classes, as I go through various option strategies, a question frequently pops up about the married put. The majority of our students are unfamiliar with the intricacies of the married put. Here I am going to explain, in a simple and easily understandable way, what a married put is.
- In one sentence: A trader is long 100 shares and also long a single put contract.
Buying a hundred shares could be done with or without buying a put, so let me give both scenarios.
Scenario Without Options
If an equity trader is holding a bullish outlook on a product that is currently trading at $40 per share, then the trader could simply proceed with the outright purchase of the underlying product. In such case, the trader does not have any protection from downside risk, with the exception of the trader's stop loss. Whenever the product decides to move up, the trader will be profitable, and if the trade does not move up, then the trade might get taken out on the hard stop loss.
The reason why I emphasize the word "hard" is because a lot of traders have a stop loss which is a "mental" stop loss. It exists only in their heads and it has not been mechanically entered. Hard stop losses are mechanically entered on the trading platform and are, by default, good for only 90 days.
In my classes, I always explain the fact that GTC does not truly mean "Good (Un)til Cancelled," but good for only 90 days. At any rate, if the trader enters a mechanical stop loss, then that is the only protection that he or she has against the product moving against his or her favor. Is there any other solution to elevated risk from the downside? Yes, and it is called a married put.
Scenario with Options
If the same trader is feeling bullish on a stock, but he or she does not want to assume a big risk, then the trader could use put options for protection. In such a case, he or she would buy 100 shares of the underlying at its current price, for instance at 40, and as soon as he or she got filled on his or her order, the trader could also buy a single put option contract for protection from the downside risk.
Specifically, he or she could purchase an ATM (at-the-money) put, which would have a strike price of 40 and expiry of, let's say, 90 days out. The moment he or she gets filled, the position is somewhat delta neutral, for the trader is long 100 shares and he or she is also long a single put contract which also controls 100 shares; being long 100 shares gives a delta of 100, and being long a put gives a negatively correlated delta.
Let us assume that technically speaking, he or she is in an exactly delta neutral position for the positive and negatively correlated delta should cancel each other out. (By the way, the truth of the matter is that the ATM put always has a -0.50 delta, yet for the purpose of the educational discussion that I have in mind, we will close our eyes temporarily to this truth.)
The trader, long 100 shares and also long a single ATM put, knows that he or she has a hedged position on; so let us see two possible scenarios.
What Happens if the Underlying Goes Up?
If the product moves up in value to, let's suppose, 55, then his or her underlying would increase in value by 15 points since the product was purchased at 40. At the same time, the long put—which by default makes money when the price moves lower—has in fact lost value. If the option contract is held until expiry and the price is 55, then the put contract expires worthless and the trader's loss is limited only to the cost of the premium paid for a single put contract. Let us assume that the cost of a put was $3.50, or $350 for each contract controlling 100 shares and 3.50 times 100 shares equals $350.
NEXT: The Math for the Bullish and Bearish Scenarios |pagebreak|
The Math for the Bullish Scenario:
Bought 100 shares @ 40 = $4,000
Bought one ATM put for = $350
Total cost = $4,350
Sold 100 shares @ 55 = $5,500
Profit equals (5,500 - 4,350) $1,150
Now let me put a disclaimer that the profit has been made with a risk of $350 or the cost of the put contract. Had there not been a put, then the profit made would be made with the risk of the total capital invested: $4,000. It is true that the profits would be higher ($1,500 to be exact), yet the risk would also be higher. The exposure would have been $4,000 at any time during the extent of the trade.
By contrast, had the directional bias been wrong, and the underlying had declined to 30, what would the outlook be then?
The Math for the Bearish Scenario:
Bought 100 shares @ 40 = $4,000
Bought one ATM put for = $ 350
Total cost = $ 4,350
Sold 100 shares @ 40 through put = $4,000
Loss equals (4,000 - 4,350) $350
Comparing the Two Scenarios
When comparing these two outcomes, the bullish outcome gives us a profit of $1,150, while the bearish outcome gives us a loss of only $350. The reason why the trader was able to sell 100 shares of his or her stock at $4000 was because of the ownership of his or her put contract. Once again, the long put contract gives us a right—but not the obligation—to sell a product at the strike price.
Observe how in this example, I did not even entertain the possibility of selling the put for profit. The sole purpose of this trader's purchase of a put was to protect his or her stock ownership from downside risk. If the downside risk had materialized, then the trader would be able to get out, because of his or her protection, with the minimum loss, the amount of premium paid for the put.
Had there not been the put, the loss would equal whatever the distance was to the mechanical or hard stop loss. However, due to the fact that there was a put, the risk was eliminated. Even if the price went as low as it wished, the put would protect the 100 purchased shares and the trader would be able to get out of his or her bad trade for a small loss of $350.
Wrapping It Up
In conclusion, the married put acts just as insurance on a car or home. If time passes by and the car does not get into a collision or the house does not burn down, the insurance expires unused. However, if something goes wrong, then the insurance contracts become extremely valuable.
Trading stock directionally to the upside without the use of put options is riskier than trading them with married puts. They are costly, yes, but the current financial situation would be much different for many Americans had they known about the usefulness of married puts. Learn more about options and protect yourself with them. Have a green trading day!
By Josip Causic of Online Trading Academy
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