Most individuals go out of their way to be sure they protect important assets
in their life. For example, there is Life insurance to insurance against loss of
life and to protect family and loved ones who must go on living without you, and
although you are gone, at least the financial burden that would be left upon
them, can be at less partially alleviated.
For the beginner or novice investor a PUT is the right, but not the obligation, to sell a stock at a specified price, within a specified period of time.
For those of you who have not utilized the put, we are only going to talk about one use of the power of the put. The use we will talk about is the power of the put when used as insurance
The Put use, as insurance would have saved a lot of loss in one's portfolio
Imagine you owned
the high-flying tech stock XXX and purchased it, with its high
valuation and no projected earnings, for $85 a share. This stock has just moved
up $12 a share two days ago, and another 3 points today. Wow! What a stock. You
really got to love it. So you buy 200 shares at $85 and off you go into the
sunset. Unfortunately, as with most investors, this is how the story begins and
ends regarding purchases of this type. XXX just announces it will only loss 2
million in the 2nd quarter of
this year. So what! The stock jumps another 7
points to $92 and you buy another 200 shares, giving you 400 shares with an
average cost of $88.50. Our story continues 2 months later the stock is trading
at $125. Now at this point, and actually sooner, had this been an automobile
purchase we would have no doubt purchased Automobile insurance, not to mention
the fact there is a state law that requires most driver's to carry liability
insurance, we would have also purchased property damage
to protect our car as
well. It is the purchase of property damage to protect our automobile, is where
we draw the analogy to the put option. Let's say our automobile is worth
$50,000, a nice round number.
Figure 1: Automobile Insurance
Now let's say this property damage covers your car for any loss that would happen to your vehicle for 1 month ($200) so that if something happen to your auto. You could easily have your auto repaired or in the worse case scenario, have it replaced if it were totaled or stolen. In this case the $200 covers the total value of your car. (It is like having a ZERO deductible.
Now lets examine our $125 stock. We can do the same thing with our XXX stock to insure it against loss as we did with our Automobile. We do this by buying a PUT. In the case of our stock we will buy a 1-month premium for $200 for very 100 shares we own, to protect our stock from any loss below $125.
Figure 2: Stock with Put insurance
Now let us continue our story. Well what happens next, you all remember. The High Tech stocks crashed from their ridiculous Price/Earnings ratios perches and it was not until nearly a year later did it finally sink in what hedging and portfolio insurance really meant and could do for the average investor.
In our story, XXX dropped to 22 around the 2nd week
of May. Our investor who
purchased 200 shares at $85 and 200 more shares at $92 watched his $35,400
investment rise up to $125 or $50,000 only to see it one month later at $8,800.
A loss of $26,600.00
As you can see devastating losses. However, losses that could have been
Remember in Figure 2: We purchased 4 puts at the strike price of $125 at $200 a piece for a total of $800 debit ( Our Insurance )
Now let's look but at how our story could have and should have turned out.
If is now again, the 2nd week of May and once again you are out looking at XXX trading at $22 a share. Only this time you have a completely different perspective on you portfolio.
Remember the puts that we
purchased for the net debit of $800 gave us the RIGHT
to PUT or SELL XXX at $125 a share no matter what happens. Well XXX is at $22 a
share. We now have the right to Sell that stock of put it to the seller of the
put that we purchased it from. Never mind who it is at the moment, we will
explain the exercise process in a later article. But the point here, is that you
can sell those 400 shares of XXX at $125 a share and you will receive $125 a
share or $50,000 (less the $800 you paid for
the Put premiums. What a BIG
DIFFERENCE in the net value of your portfolio your car. Instead of losing over
($26,000) from the XXX investment, we could have made a NET PROFIT of $13,800
dollars. That is $13,800 Profit vs. $26,600 loss. That is a $40,400 turn