A lot of investors think of options as being exotic securities that are best avoided. That can be true, but even if you’re a less-experienced investor, you can make some basic options plays that will add extreme value to your portfolio.
Puts are one of the most basic option trades out there. The concept is simple. You are forming a contract with another options trader in the market. You are agreeing to purchase the right to sell (put) a certain amount of stock to the trader at a certain price (strike price) on or before a certain date (expiration date).
You don’t have to actually own the stock to do this. Your broker will execute a simultaneous transaction whereby you will purchase the stock at the price on expiration day, then immediately sell it at the strike price. Obviously, you hope the stock will be lower than the strike price, because then you profit from the difference.
However, you also can use so-called “protective puts” — where you buy put contracts against stock you hold — to protect your long positions. For instance, let’s say you hold energy stocks but are worried about a continued slide in oil prices. You could sell out of your position, but if you do and the stock suddenly recovers, you miss out on the upside. But if you merely buy protective puts, your downside is protected, and you can still profit should your shares rebound.
Here are three great examples of protective puts to use against popular stocks:
Protective Puts: ConocoPhillips (COP)
Let’s take ConocoPhillips (COP) which closed Monday at $49.56. You hold 300 shares and are worried COP stock will fall in the next month or so.
You could purchase three contracts of the COP Sep 18 $50 puts at the going price of $1.88 per share, or $188 for a contract of 100 shares. Thus, you have spent $564 to protect your COP stock position if ConocoPhillips falls below $50 before Sept. 18. If COP closes above $48.12 by then, you put will be worth less than $1.88 and you will have lost money. If it closes below $48.12, the options will be worth more than you paid for them.
If COP stock closes at $46, they are worth $4 per contract, or $400 each, for a total of $1,200. It will offset your holding of 300 shares that are now $4 below $50.
Protective Puts: Microsoft (MSFT)
Let’s suppose you own Microsoft (MSFT). You are concerned that MSFT stock may be headed lower for some reason, or that its next earnings report in October will be bad. Let’s say you own 300 shares, currently priced at $47. You can buy three contracts of the Nov 20 $48 puts for $2.75 each, or $825 total.
Why are they more expensive that COP stock’s puts? First, prices depend on how volatile the stock itself is. Second, the further out you choose to buy puts, the more time can pass during which the stock could have anything happen to it. So the option has a certain time premium built into it.
If MSFT stock closes below $45.25 by expiration, your puts will be worth more than you paid for them. Their increase in value will offset the decrease in value of Microsoft. Also, you don’t have to wait until expiration to execute the contract. If MSFT stock, say, suffers a catastrophic fall to $30 before then, you could sell those contracts for $18 each, and offset the $18 per share loss in Microsoft.
Protective Puts: Chipotle (CMG)
For very expensive growth or momentum stocks, you’ll have to pay a lot to purchase puts. Let’s take Chipotle (CMG), which trades at $754 per share. Just to buy protection through Aug. 28 for the $755 strike price, you would have to pay $10 per contract, or $1,000 for each 100 shares of CMG stock you want to protect.
Want to be protected until mid-December? One put contract on CMG stock will cost you $4,350. That’s why using options on these kinds of stocks is just crazy. The only time I suggest such a thing is if you 1) feel very certain a decline is likely, 2) are close to expiration date so you aren’t paying a lot of time premium, and 3) don’t overpay for protection.
That’s why buying a put that is “out of the money” may make more sense. You buy a put, in this case, that is $30 or $40 below the current price. It means you are giving up some protection on that amount, but the puts will be cheaper.
The Dec 18 $700 put, for instance, costs $22, or $2,200. You lose any protection above $700, but you’re still covered in the event of a severe drop.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
