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Options Trading: The Insurance Put

Posted January 7, 2010

Topics: Finance & Investing

Puts are not just for bearish sentiment. True, as a bear you can buy puts thinking the stock’s price is moving south. But you can also buy puts to protect paper profits when your stock’s price runs up quickly.

How often have you found yourself in this situation? You buy stock and its price jumps nicely, creating some handsome profits. The immediate impulse is to take profits while you have them. You know there’s a chance that price will retreat, but what if you take your profits and the price continues moving up? In that case you lose out. There is a solution. You can protect your profits without selling stock.

When you buy puts, the value of those puts rises as the stock’s market value falls. This makes puts ideal for protecting profits, especially in the short term. If the put has a long way to go before expiration, you’ll be paying a lot for time value, which makes the put too expensive. But when you think about the purpose in buying the put -- protecting quickly developing paper profits -- you really need the insurance for the short term.

In this situation, you probably get the best bargain buying puts that are going to expire in the next four to six weeks, at a strike price close to current value but out of the money. This is where you are going to find the best bargains.

For example, let’s say you buy 100 shares of stock at $26 per share, and after an unexpectedly favorable earnings report, the price jumps up to $31. You don’t want to sell but you like that $600, a 23% profit. If you buy a 30 put, expiring in four to six weeks, you get the following benefits:

  • The put is going to be fairly cheap because it expires soon and is out of the money (at “at the money” put means the strike and market value are identical; an “in the money” put means the put’s strike is higher than current market value)
  • There will be very little time value, so if the stock does move below the strike, the put will tend to increase in value one point for every point lost in the stock. This means your 100 shares are protected at about $30 per share (the strike) for the next few weeks.
  • Since price corrections tend to take place fairly soon after an exaggerated price move, you will probably get maximum benefit from this insurance put within a very short time, usually a matter of two or three sessions.

Why is the insurance put preferable to just selling shares? Remember, if you sell and price goes down, you can easily re-purchase them. But if the price goes up, you lose out on future profits because you sold too soon. Since you cannot know with certainty how the stock will move, the insurance put is a reasonable alternative.

You can also consider selling a covered call, also protecting paper profits while yielding you a cash return for selling the call. You keep the profit no matter what; but if the stock’s price rises above the strike, you stand to lose out on future profits. The short call will be exercised, meaning you only get the value of the strike. Of course, if the bought the stock at $26 and sell at $30, that’s still a decent return. And remember, you not only keep the covered call premium; you also earn dividends for as long as you own the stock.

Whether you decide to go with the long call or the short put, the important fact is that you can protect paper profits without selling stock. Options provide you with a range of good choices.