How to Hedge a Stock Position Using Put Options


Put options are a type of insurance contract designed to prevent the loss of money when a stock falls in price rapidly.  A put option is a legal contract that gives the individual who buys the put option the “option” — not the obligation —  to sell 100 shares of a stock for a fixed price (the strike price) on or before a certain date (the expiration date).  The person who creates the put option is called the put writer since he “writes” the legal contract.  (In actuality, no physical contract is written, the person wishing to write the put option simply calls his broker and indicates he wishes to write the put option; gives the stock name, expiration date, and strike price; and then the option is created.

The strike prices for put options are at specific intervals of the stock price.  At lower stock prices the strike prices are at smaller intervals and they spread out as the price of the stock increases.  The expiration dates are also specified at regular intervals, with options expiring on the third friday of the month (for example, a June option would expire on the third friday in June).

In exchange for agreeing to buy the stock at the fixed price, the option writer collects a premium from the option buyer, just as a car insurance dealer collects a premium to ensure an automobile.  The price of the premium depends on two factors, the difference between the current stock price and the strike price, called the extrinsic value, and the time remaining on the option, called the intrinsic value.  Note that the volatility of the underlying stock is also a factor, since stocks that move up and down rapidly are more likely to move below the strike price at some point before the option expires than are stocks that are fairly stable.  The intrinsic, or time value of the option tends to stay fairly stable until about 90 days before expiration, at which point the value decays rapidly.

While options are used commonly for speculation, the only suitable use of options for serious investors is in their pure use, that as an insurance contract to protect against losses.  For example, say an investor had 1000 shares of XYZ corporation and had a good profit, but already had a lot of capital gains for the year and wanted to avoid taking the gain for a few months until the new year started.  The investor might buy 10 January put options with a strike price a few dollars below the current price of XYZ.  In that way, if XYZ fell in price before the expiration date in January, the investor would limit his loss since he could sell his shares at the strike price.  He would also lose the premium paid if he exercised the option.

Once purchased, put options can be sold and the position closed by writing another put option of the same strike price and expiration date.  For example, if our investor bought 10 January 50 put options to cover his 1000 shares of XYZ from losses, and the price of the stock dropped to 40, his put options would now be worth $10 (the extrinsic value) plus the remaining intrinsic value.  The premium might now be $11 or $12 or more, depending on how long it was before the options expired. The investor may decide that he would rather keep his shares, now that the price has fallen and seems less rich, thereby avoiding a capital gain on the stock or the costs of closing the position and buying the shares anew.  Because the investor has the option to sell the shares, rather than the obligation, instead of exercising the puts and selling the shares he may decide to write 10 January 50 put options.  This would then close the position by creating an offsetting obligation, collecting $11 in premiums, say, and he would be able to pocket the difference in premiums.  If he originally paid $3 for the put options, he would pocket ($11-$3)*1000 shares = $7000.

Note that just as few people use their automobile insurance during any given policy period, few put options expire with the stock price lower than the strike price.  Because the probability that the stock will be below the strike price at the expiration date is priced into the premium paid for the option, most individuals who buy put options will lose a little bit of money compared with just selling the shares outright.  It is therefore not a good strategy to buy put options repeatedly.  Instead, they should only be purchased when the investor wants to stay invested for a short period longer, but is worried that the stock may suffer a sudden drop in price. 

They may also be used when, for some reason, the money will absolutely be needed within a few months to a year but the prospects for the shares are so great that one does not just want to sell the shares now.  For example, there are rumors of a takeover or a short squeeze is likely.  90% of the time, however, it is better to just sell the shares if the money will be needed and avoid paying the premiums to buy calls.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.