Don’t Overpay for Put Protection

06/06/2011 9:57 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

This trade example proves that buying front-month put options to protect against a decline in the stock isn't always the most cost-effective way to protect your investment.

A lot of investors are enamored by the almighty put, especially buying the shortest-term, or front- month, put for protection. The problem, however, is that there is a flaw to the reasoning and practice of purchasing front-month puts as protection.

Yes, it’s true that front-month contracts have a higher Theta and relying on front-month puts to protect a straight stock purchase is not necessarily the best way to protect an investment. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to buy insurance.

Although front-month options are often cheaper, they are not always your best bet. The reasoning may be sound—the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his position—but sound reasoning does not always lead to good practice. Let’s take a look at an example.

A hypothetical stock is trading a slightly above $13 and our trader wants to own the stock because he/she thinks the stock will report blowout earnings in each of the next two quarters. This investment will take at least six months, as the trader wants to allow the news events to push the stock higher.

Being a savvy trader, he/she wants some insurance against a potential drop in the stock. The trader decides to buy a slightly out-of-the-money July 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That $0.50 premium represents almost 4% of the current stock price. In fact, if the investor rolled the option month after month, it would put a big dent in the initial investment. To be sure, after about seven months (assuming the stock hangs around $13), the trader would lose more than 25% on the $13 investment.

What if the stock drops? That is the ultimate rationale for the strategy in the first place: protection. The put provides a hedge. The value of the option will increase as the stock drops, which counterbalances the loss suffered as the stock drops. Buying the put is a hedge, a veritable insurance policy—albeit, an expensive one. Investors can usually find better ways to protect against a decline in the stock.

By Dan Passarelli of Market Taker Mentoring

Dan Passarelli is an option trader and educator and has written a free option trading report.

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