Which Put Option Should You Buy?

09/17/2012 8:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Dan Passarelli explains why this common option strategy can become more trouble than it's worth quickly.

A lot of traders, especially those who are just learning to trade options, 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. Ah, yes; it’s true. 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 by 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.

We will use a hypothetical trade today. The stock is trading at slightly above 13 and our hypothetical 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 options trader, our stock trader 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 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 and traders can usually find better ways to protect a stock.

Dan Passarelli can be found at MarketTaker.com.

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