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Educational Article

The Power of the Put

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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.
The same is true regarding Health Insurance, disability insurance, homeowners or any insurance that one may purchase. Its about reducing the risk of a potentially life altering event. However, it seems ironic, that we do not take the same precautions with the money that we have put in our investment portfolios. You know those portfolios that use to have those household sounding names like Sun Microsystems, Nortel, MCI, Ramous, Lycos, Real Networks. Need I go on? It was not that long ago when individuals were basking in the glory of double and triple returns on an annual basis from their High Tech Stock darlings. But how quickly things can turn around, if seems, without any real notice. Especially when one fails to hear the cry of, over valuation, absurd Price earning ratios. These are a few among the many messages that the average investor failed to heed. When the crash came, it took no prisoners, and fortunes that seemed to be made in the course of only a few months, seem to dissipate even faster. With only one double top warning it happen. The Great Tech Valuation Crash! How all too well we remember the time. A lot of this emotional and financial pain could have and should have been avoided. Just as individuals would not think about going uninsured and gambling on their health, Life and the home they live in. Investors had the same option to insure their portfolios and investment from risk. If we learn nothing else from History, it is that History tends to repeat itself. Excess and overvaluation at any junction in our history has always led to eventual corrections in regard to that excess. If individuals would have taken the same attitude when examining their portfolios, a lot of carnage could have been avoided. Sure, there would have been losses, but sustainable, tolerable losses, had individual investors understood the true value and the use effective use of the Put option.

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 value.
Imagine, the Put the purchase of a put like an automobile premium, but instead of covering your auto this premium covers a particular individual stock that you own.
When you purchase this Put option you pay a premium, just as you would when you buy automobile insurance. Additionally, when you purchase a Put option you can also select a deductible, in the investment world this deductible is referred to as a strike price. Let's look at a hypothetical example, and then move on to a real world situation.

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.
and our insurance including property damage is $275 a month.

Figure 1: Automobile Insurance
               Liability coverage $75
               Property Damage $50,000 ($200 - Zero Deductible)

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
               400 shares XXX @ $125 = $50,000
               Purchase 4 XXX May 125 Puts @ 200 each = $800

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
In real dollars and a loss of $41,200.00 from the XXX top of $125

As you can see devastating losses. However, losses that could have been minimize.
Lets show you how.

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 around!!
 

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