How I use put options as investment insurance

There were 7 new highs and 1,221 new lows in my universe of 4,000 stocks on Friday.   The QQQQ completed the 14th day of its short term down-trend within a longer term down-trend. I heard on Fast Money that the AAII survey has the most bearish reading ever.   Furthermore, the momentum indicator in IBD for the Nasdaq 100 index futures is below 25%, the place from which   rallies tend to begin.   And with the T2108 at 7%, in deeply oversold territory, I am becoming reluctant to add more shorts right now.

Last week, a person who knows nothing about the market asked me how to short stocks.   This is reminiscent of the   stories of the shoeshine boys providing stock tips, near the roaring 20’s market’s top.   The sentiment is just too negative right now.   Does this mean the market has to turn up?   Not necessarily, but the market is always an assessment of competing probabilities.   I am looking to protect my short profits if we get a major bounce up….

Speaking of protection, I have been using put options, rather than stop losses to protect my   few long positions.   A put option gives the owner of the put the right, but not the obligation, to sell 100 shares of a stock at a fixed price (strike price) for a set period of time (through option expiration). My broker allows me to purchase puts in my IRA.   (To do so, one must fill out an option account application and have it approved.)

Let’s take an example.   Say I think that gold is going to rise.   I could buy 100 shares of the gold ETF, GLD, at Friday’s closing price of   $92.29 per share, for a total cost of $9229, excluding commissions.   I could then place a GTC (good til cancelled) stop order to sell the 100 shares if it subsequently trades at say, $89.00.   Then, if GLD were to fall anytime to $89 or below I would be immediately sold out at market, with a loss of at least $3.29 per share (89-92.29)   plus commissions.   However, if GLD suddenly gapped down and opened one day way below $89, I could get sold out much lower than $89 and have an even larger loss. Worse still, what if GLD trades below $89, I get sold out, and then the stock climbs much higher without me.   That never happens, does it?!

Instead of placing a stop loss order to sell out 100 shares of GLD at 89, I could purchase a March put option to sell 100 shares of the stock at the $89 strike price, good through March 20.   (I could buy an option good for a later month, but it would cost more.)   I can go to Yahoo Finance (or my broker’s site or any other quote site) and enter the symbol GLD and click on “options” and get the March call and put option prices.   Options are traded on exchanges just like stocks are. If   I scroll down to the put options section and look at the strike price of 89, I see that these options closed at $1.20 with   $1.15 bid, $1.25 offered.

This means that I can place an order to buy 1 put option “at market” (or with a limit of $1.25) and expect to pay about $125 (each option covers 100 shares) per option, plus commissions.

Now I will own 100 shares of GLD plus one March 89 put option.   This means that I can sit back and relax, knowing that if before option expiration on March 20, GLD is selling below $89, I can call my broker and instruct her to exercise the put, and sell my 100 shares at $89.   Even if GLD is trading at $1.00 per share, I can still sell my shares at $89!   In addition, if   GLD falls below $89 anytime before March 20 and then rallies above $89, to say, $100, I am still holding my shares.   I do not get sold out and then whipsawed, as could happen with a stop loss order!

The put option merely expires worthless if the stock is selling above $89 at expiration.   Why would anyone put the stock to someone at $89, when s/he could get more by selling in the open market.

What is the downside of using the put this way?   Well, the cost of the put (plus commissions) is added to the total transaction cost.   Thus, in the example above, if I exercise my put, I lose $4.54 per share:   (89.00-92.29 – 1.25) x 100= $454 plus commissions.   Clearly, this is about $125 more than I would lose if I had just used a stop and been stopped out.   Similarly, if the stock goes up and I sell my shares, I have to subtract the option price, $125,   from   my profits.   Now, tell me, do you complain each year about losing the insurance premium you paid on your house, if your house does not burn down?

I find that buying a put option to protect stock I own is an especially comfortable way to bet on a rise, without becoming frazzled and whipsawed by this volatile market.   At least I know from the outset that I have set the most that I can lose on a transaction.   If you like this strategy, get a copy of the option instructions available at many option sites. It is probably a good idea to let your broker walk you through your first options trade.

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