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Options Trading: Why Buy Insurance Puts?

Posted June 13, 2012

Topics: Finance & Investing

The insurance put protects your appreciated stock by limiting losses in the event of a price adjustment. But it only works under specific circumstances.

The insurance put is one long put, purchased to protect 100 shares of stock. If the price declines, the insurance put can be sold or exercised to eliminate the paper loss.

But it only makes sense if the following conditions apply:

1. You are bullish. You believe the price will continue upward and you would prefer to not sell shares right now.

2. At the same time, you realize a correction can occur and you want to protect your profits.

3. You know how to pick the right strike. This usually is a strike close to current price but below it. The out-of-the-money put will cost less than one in the money.

4. The cost of the put will not take up all of your profit. If it does, the strategy is not economically rational.

For example, you bought 100 shares of stock two years ago at $72 per share. Today it is worth $86. You can buy a four-month 85 put for 2.50. This is a good price, due to the put's being slightly out of the money. Your breakeven is $82.50 per share (85 strike minus the 2.50 you pay for the put).

If the underlying price falls below that level, you can sell the put and take the profits. The intrinsic value of the put will offset losses in the stock point for point. You can also exercise the put and sell your shares at the fixed strike of $85. You can do this no matter how low the stock's price falls, as long as you act before expiration.

The insurance put is a great defensive strategy as long as these conditions exist. It enables you to avoid losses in the event of a decline, and to protect profits in the hope of further upside price movement.