Using Put Options To Protect A Portfolio Of Stocks

*** The following is a guest post from Gavin McMaster founder of Options Trading IQ ***

Markets took a beating recently due to the coronavirus outbreak and while they have recovered slightly, I thought it would be a good time to look at how to use put options to protect a portfolio of stocks.

The S&P 500 peak in mid-February at 339.52 and subsequently fell to a low of 2,191.86 on March 23rd. That was one of the most severe and rapid declines in market history. The 35.41% decline took a lot of investors by surprise and saw the portfolio gains from the last few years evaporate.

What Is A Put Option?

Put options are securities that are used by hedge funds, money managers and professional traders to protect their portfolios from drawdowns like the one we saw recently.

Investopedia gives the definition of a put option as:

“….a contract giving the owner the right, but not the obligation, to sell, or sell short, a specified amount of an underlying security at a pre-determined price within a specified time frame. The pre-determined price the put option buyer can sell at is called the strike price.”

Basically, what that means is that put options give the owner the right to sell their stocks at a certain price, no matter how low they go.

Think of it like an insurance contract that protects you against the worst-case scenario. Just like an insurance contract, you need to pay a premium for this right.

How Do Put Options Work?

Put options will increase in value if the underlying stock declines in price. Assume XYZ Corporation is trading at $100 and an investor owns 100 shares and wants to protect their capital below $95.

To do this, they could buy a three month $95 put option and might have to pay $3 for this contract.

If XYZ runs into financial difficulty and goes bankrupt, their shares go to zero.

Thankfully for our investor, they own a put option at $95 which gives them the right to sell their share for $95 even though the value of the shares has gone to zero.

In this case, the investor has lost a total of $8. That’s $5 for the decline in share price from $100 to $95 and the $3 in premium paid to purchase the put option.

This strategy is a risk management strategy known as a protective put and is used extensively by investors with large portfolios. By implementing this strategy, they know in advance what their absolute worst-case scenario is.

What’s The Downside?

Buying put options is a great risk management tool, but like any investment strategy, there is always a risk.

If XYZ doesn’t drop and instead remains at $100 when the option expires, the investor has effectively lost 3% due to the put option they own becoming worthless. In this case, the investor would underperform someone that didn’t use this protection strategy.

The same can be said if XYZ rallies. The protective put strategy will always underperform by the cost of the put option during a bullish run. But they can still be worth it for peace of mind.

Real-World Example

Let’s look at a real-world example. For simplicity’s sake, let’s say that an investor owns 100 shares of SPY as their portfolio.

With SPY trading at $287.60 that represents an investment value of $28,760.

If SPY dropped 25%, the investor would lose $7,190.

A July 17th $260 put option is trading around $13. If the investor were to buy that put option they would be able to sell their shares for $260 no matter what happens.

The table below shows how the protective put strategy compares with outright stock ownership.

Volatility is pretty high right now which means put options are expensive. When markets are calm, put options a lot cheaper. That $260 put might only cost $6 instead of the $13 it currently costs.

Summary

    • Buying put options is a protection strategy used by money managers and professional traders.
    • Put options can limit the downside risk on a stock or portfolio of stocks.
    • Put options become more expensive when market volatility is high.

Thanks for reading.

Gavin McMaster

Options Trading IQ

Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Gavin has written 8 books on options trading and you can find more from him at www.optionstradingiq.com

Subscribe To Our Newsletter

Brandon Beylo

Value Investor

Brandon has been a professional investor focusing on value for over 13 years, spending his time in small to micro-cap companies, spin-offs, SPACs, and deep value liquidation situations. Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.

Brandon has a tenacious passion for investing, broad-based learning, and business. He previously worked for several leading investment firms before joining the team at Macro Ops. He lives by the famous Munger mantra of trying to get a little smarter each day.

AK

Investing & Personal Finance

AK is the founder of Macro Ops and the host of Fallible.

He started out in corporate economics for a Fortune 50 company before moving to a long/short equity investment firm.

With Macro Ops focused primarily on institutional clients, AK moved to servicing new investors just starting their journey. He takes the professional research and education produced at Macro Ops and breaks it down for beginners. The goal is to help clients find the best solution for their investing needs through effective education.

Tyler Kling

Volatility & Options Trader

Former trade desk manager at $100+ million family office where he oversaw multiple traders and helped develop cutting edge quantitative strategies in the derivatives market.

He worked as a consultant to the family office’s in-house fund of funds in the areas of portfolio manager evaluation and capital allocation.

Certified in Quantitative Finance from the Fitch Learning Center in London, England where he studied under famous quants such as Paul Wilmott.

Alex Barrow

Macro Trader

Founder and head macro trader at Macro Ops. Alex joined the US Marine Corps on his 18th birthday just one month after the 9/11 terrorist attacks. He subsequently spent a decade in the military. Serving in various capacities from scout sniper to interrogator and counterintelligence specialist. Following his military service, he worked as a contract intelligence professional for a number of US agencies (from the DIA to FBI) with a focus on counterintelligence and terrorist financing. He also spent time consulting for a tech company that specialized in building analytic software for finance and intelligence analysis.

After leaving the field of intelligence he went to work at a global macro hedge fund. He’s been professionally involved in markets since 2005, has consulted with a number of the leading names in the hedge fund space, and now manages his own family office while running Macro Ops. He’s published over 300 white papers on complex financial and macroeconomic topics, writes regularly about investment/market trends, and frequently speaks at conferences on trading and investing.

Macro Ops is a market research firm geared toward professional and experienced retail traders and investors. Macro Ops’ research has been featured in Forbes, Marketwatch, Business Insider, and Real Vision as well as a number of other leading publications.

You can find out more about Alex on his LinkedIn account here and also find him on Twitter where he frequently shares his market research.