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.

Covered Call Writing – How to make (most) any Stock Pay a Dividend

Today I’m going to discuss a strategy called “covered call writing.”  This is about the only type of option strategy that is worth doing since the others generally require a lot of time and the odds are about 50-50 at best that you will make any money.  Also, the transaction costs and taxes  are high which further cuts into any profits.  If you are wanting to just play around and get some excitement, feel free to take a small, limited amount of money (that you are willing to lose, because you probably will) and try to time the market and buy calls and puts.  If you are serious about growing wealth, however, and want to make some income from your investments during stagnant periods where the market is not moving, covered call writing is a strategy to consider.

Covered call writing and its inverse strategy, collateralized put writing, is actually fairly conservative.  For the basics of options see the previous post, .  As stated there, a call is a legal contract that allows a party (the person who buys the call) to buy a fixed number of shares of stock at a pre-selected price (called the strike price) on or before a certain date (called the expiration date) from the person who created the contract, the call writer.   Each call normally gives the party the right to buy 100 shares of the stock it is written on. 

In exchange for this right, the call buyer pays the call writer an amount per call, called the premium.  The premium value is generally set through an open exchange (the Chicago Board Option Exchange) at which options are traded in a manner like common stocks.  Here, instead of trading shares of stock based on the share price, options are traded based on the premium value, with trades being made (contracts created) when a buyer and writer can agree on a premium amount..  The premium value goes up and down depending on a variety of factors related to how likely it is that the option will be worth anything before the expiration date and how much the option currently is worth (if it were exercised and the shares bought right now).  

The option buyer is hoping that the stock will go up in price before the expiration date so that the option will be worth more and he can either sell the option to another person or exercise the option and then sell the shares.  For example, if he has an option to buy XYZ corporation for $10 and XYZ is trading at $15, he can exercise the option, buy the 100 shares of XYZ for $10 per share, and then sell them for $15 per share for a $500 profit. 

In covered call writing, the investor takes the part of the call writer.  In order to write covered calls, an investor must have the shares in her account (if not, that is called “naked” call writing which is extremely risky) and be willing to part with them if the share price goes up.  The investor then tells her broker that she would like to write covered calls on the stock, gives information on the expiration date and strike price, and either enters a market order or a limit order on what premium would be acceptable, just like with a stock.  Note that the options markets set up specific strike prices and expiration dates, so the investor selects one of these based on the current premium offered and other considerations.

Once the option is written, the call writer begins to wait until the expiration date.  If the stock stays below the strike price during that time the option will probably not be exercised and will expire, allowing the writer to keep the whole premium.  This is like getting a dividend on the stock, which tends to average about 15-25% per year if done right.   If the stock is above the exercise price the shares may be purchased by the call buyer or the writer must purchase another, offsetting call before the original ooption is exercised.  If the stock drops in price the call writer will lose money but the premium collected will reduce the loss somewhat (which is why it is more conservative than buying stocks outright).

The beauty of the strategy is that it allows individual who have large stock positions and wish to generate current income to turn any stock into an income source.  The premium will be considered a short-term capital gain for taxes.  The downside is that it limits capital gains since if the stock moves above the strike price before the expiration date the shares will be purchased by the call writer and taken away.

In the next post I’ll discuss how to select which calls to write based upon the option expiration date and strike price.

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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.