Option Investor
Educational Article

The Power of the Put (Part II)

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If you remember from our last discussion, we learned how the put option could be used as an insurance hedge for our stock, similar to our automobile insurance coverage. We discussed how the purchase (Long) of a PUT could protect your stock from downside risk.

In review a PUT is the right, but not the obligation, to sell a stock at a specified price, within a specified period of time.


Let's go back to our highflying XXX stock that went from $85 a share to $125 a share. If you remembered we purchased 200 shares at $85 and an additional 200 shares at $92 a share for a total of 400 shares @ an average cost of $88.50 or a total cost of $35,400
(See figure 1 below)

We then proceeded to purchase our PUT options, The 4 XXX May 125 puts @ a cost of $200 each, to cover our 400 shares of XXX. This transaction cost a total of $800. (Plus commissions)

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(See net position below)

Figure 2: Stock with Put insurance
400 shares XXX @ $125 = $50,000
Purchase 4 XXX May 125 Puts @ $200 each = $800

We in essence, did the same thing with our XXX stock to insure it against loss as we do when we purchase our Automobile insurance. (See figure A & B below)

Figure A: Stock with Put insurance
400 shares XXX @ $125 = $50,000
Purchase 4 XXX May 125 Puts @ 200 each = $800
Figure B: Automobile insurance on our $50,000 car

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

REMEMBER: The Long put is most like purchasing Property damage coverage on your automobile.

You then remembered in our example what happen to our $125 XXX stock? It went down to $22 a share. However, because we had the PUT insurance off the May 125 puts will were protected and could put those 400 shares to the market for a net total of $50,000
Less the $800 we paid for the PUT premiums. So our portfolio netted $42,000. This equaled a NET PROFIT of $13,800 versus a LOSS of $26,000 without the strategy.

Now that takes us up to The Power of Put. (Part II)

Now let's say that when XXX was $125 a share you decided that you didn't want to pay $200 a share to cover your XXX stock (or to buy the May XXX 125 puts), you still have numerous other options.

Let's go back to our automobile insurance for one second again. If you look at your policy you will see a section dealing with your property damage that mentions something called a DEDUCTIBLE. That deductible is basically saying this is the amount that you, as the policy owners, are willing to absorb or pay before the insurance company will pay off the damages. In other words, it is the out of pocket amount that you must pay first or the amount that is deducted from the ultimate amount the insurance company is going to pay you on the claim or loss. For example you might want to have a $1000 deductible before your insurance company will begin to pay off for losses, or even a $2500 deductible. The reason you look at these deductible options is that they all vary in the price you pay for them. The lower the deductible, the higher the premium that you as the insured must pay to the insurance company. The higher the deductible, the less premium you must pay to the insurance company. (See the chart below)

Figure C: Hypothetical Chart for Deductibles for Automobile Policy

As you can see, as you absorb a greater amount of the risk, by paying for a higher deductible, your PREMIUM is LOWER, alternatively if you have the insurance company absorb a greater risk, your PREMIUM is HIGHER,

EXAMPLE: Two individuals insuring the same identical motor vehicle. Driver #1 purchases a $100 deductible for his $50,000 car and Driver #2 purchases a $5000 deductible for his car.

Scenario: Both cars get into an accident and are totaled.


Notice the insurance company covers both drivers, but Driver #1
Receives a check from the insurance company for $49,900, the cost of his automobile minus the $100 deductible, while Driver #2 receives a check for only $45,000, which is the cost of his automobile minus his $5,000 deductible In this example Driver #1 pays a higher premium ($340) for greater coverage. While Driver #2 pays a lower premium ($35) for lower coverage. You all know the reason that Driver #2 selected the lower premium. Driver #2 either thought he would not be involved in any accidents and would save the difference in premium or that the premium being charged was too high to pay.

Ask yourself why you selected the deductible that you chose.

Now to get back to the reason for the above explanation of deductibles. The PUT option offers the buyer of that option alternatives similar to the deductibles offered by the automobile insurance company. These alternatives come in the form of STRIKE PRICES.

Remember our XXX stock at $125, if we felt that $200 for a May XXX put option @ 125 was too high, we could purchase a less expensive PUT by buying one at a lower strike price for example a XXX May $115 put might only cost us $75 to insure every 100 shares. However, because we are paying for less coverage our protection is less, or in other words we have to give up something. In this case, using our XXX stock May sell off to $22 a share, we can put the shares to the market, but NOT at $125 a share but only $115 a share. So in comparison we can see how the XXX May $115 and the XXX May $125 put would compare with other alternative Strike Prices: (see chart below).


Chart B: Hypothetical Option Chart showing various Strike Price Choices


As you can see there are numerous choices that can be made in regards to Strike Price choices. The ultimate decision has to be made by the Buyer. Strike Prices also are available as far as 9 months out in time and in intervals of 5 and sometimes 10 strike prices. Some stocks even have .50 strike prices available due to splits and spin offs. (EX. 27.50, 37.50, 47.50)

 

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