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Options Trading: Protecting Paper Profits with Options

Posted February 10, 2011

Topics: Finance & Investing

Many traders think that options are purely for speculation, or that puts in particular works only when you are bearish on the market. But an easily overlooked additional application is the insurance put: buying puts to protect paper profits and, if the stock price does fall, to replace lost profits without having to sell stock.

An investor holds long stock and timing was good so the price rises. Now that investor has to make a decision: Do you take profits while they are available, or hold off hoping they don’t get taken back in a price retreat? The immediate impulse may be to take the profits, but what if the price just keeps rising? If that happens, you have lost the opportunity for even more growth. It’s a dilemma.

There is a solution. If you buy one put for 100 shares, that put’s value will experience one point of growth in its intrinsic value, for each point the stock price drops. “Intrinsic” value means the portion of the put that’s in the money. In other words, the stock price should be at or below the fixed strike price of the put. When this condition is found, intrinsic value is going to track the stock price exactly.

 

A potential problem is found in the co-existence of intrinsic and time value. Time value falls as expiration gets near, so there is a good chance that even if intrinsic value of the put is rising (because the stock price is falling), that profit will be offset by a decaying time value.

A solution is to buy puts close to expiration, when premium is almost all intrinsic value. This minimizes the risk of the time value offset. However, it presents a new problem: The put will expire in a few weeks.

The best insurance put is one that is at or slightly in the money, and due to expire in less than two months. But this also means that the insurance put is going to provide protection only in the short term. So if you fear a price adjustment in the near future, the insurance put is perfect for you. This device is not likely to be profitable if you want long-term downside protection. It offers the most practical protection for very short-term adjustments. For example, if price has risen very quickly and you fear an equally fast adjustment in the opposite direction, that’s the best time to buy the insurance put. If the adjustment doesn’t happen within a few sessions, it probably isn’t going to happen at all.

There is a cost involved, but if you think the p-rice will adjust, buying a put, while speculative, may also prove to be the best way to protect your stock’s market value. Unless you prefer selling shares once those paper profits appear, the insurance put is at times the best solution.

Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.