Previously, we discussed how covered calls and covered puts can help you generate income and offer limited risk protection. Now, let's go a step further and take a look at two options strategies traders often use to help hedge equity positions against market uncertainty: protective puts and protective calls.
These strategies can effectively help provide a means for exiting an equity position or offsetting losses when your stock moves against you.
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Protective puts: Long stock position and long puts in equal quantity
Protective puts are often thought of as a kind of insurance policy. If you hold a stock that might trend down in the short term, but that you believe has favorable long-term prospects, a protective put may provide short-term protection against a downturn in your equity position. To illustrate the parallel with an insurance policy, let's compare a protective put to automobile insurance.
Assume you drive a nice sports car worth about $72,000. If you wreck the car beyond repair and you have no insurance, you would incur a loss of $72,000 (less the car's salvage value, if any). This is a significant risk—most people probably wouldn't own such an expensive car without some kind of insurance.
If you had purchased auto insurance, you could get reimbursed for most or all of the value of your wrecked car. Of course, your insurance agent would probably request a very high premium payment on your policy. To reduce your insurance premium, you'd probably opt for a deductible—let's say $2,000. Even so, let's say your premium is also $2,000.
If you wrecked your car during the first quarter, your total loss would be about $4,000—the $2,000 premium you paid for the first-quarter coverage plus a $2,000 deductible. If you didn't wreck your car, you'd still be out the $2,000 premium. Most people are willing to pay this amount to avoid the potential losses of wrecking the car.
Let's apply this thinking to protective puts—keeping in mind that most options represent 100 shares of the underlying stock and their prices must be multiplied by 100 to calculate the cost when they are traded or exercised. Assume you own 1,000 shares of XYZ stock worth about $72,000. If you do nothing and the stock suddenly drops to $50, you could lose $22,000.
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To help reduce this risk, you can buy "insurance" on your stock. If you decided to buy 10 XYZ June put options with a strike price of $70, at a price of $2 (total cost $2,000), you could exercise your puts at any time prior to the June expiration and sell your stock at $70, 20 points above the current market price, or sell your puts to offset most of the loss on your stock.
If you chose to sell your stock at $70 by exercising your puts, the premium you paid for your put options ($2,000) would be your "insurance premium," and the 2 points you would lose on your stock (because you paid $72 for it, and only sold it for $70) would be your "deductible." Overall, your loss would be about $4,000—$2,000 on the stock and $2,000 in premium (the amount you paid for the puts).
If XYZ stock stayed above $70 by the June expiration, your puts would expire worthless, and the $2,000 you paid for the puts would be lost—just like the insurance premium you paid on your car.
When you hold long options, you're never required to exercise them. You usually have the choice to sell them at their market value. In other words, rather than exercise your puts and sell your stock at $70, you could choose to sustain the 22-point loss on the stock and simply offset most of that loss by selling the puts at their appreciated value. If the stock is at $50 at the June expiration, your put options with a strike price of $70 would have an intrinsic value of $20. Assuming you were able to sell them at that price, doing so would bring in approximately $20,000 ($20 per contract x 10 contracts x 100 shares per contract). This would offset all but 2 points ($2,000) of the decline in the stock.
If you did this, the $2 premium ($2,000) you paid for your put options would be your insurance premium, and the 2 points ($2,000) you would lose (since your stock lost $22 and you only sold your puts for $20) is your deductible. Overall, your loss would still be $4,000—$22,000 you lost on the stock, less $2,000 in premium you paid for the puts, plus $20,000 you received when you sold the puts.
If no bad news occurred and the company's stock stayed at or near $72, your puts would expire worthless, and the $2,000 you paid for the puts would be lost, just like the insurance premium you paid.
When establishing a protective put position, investors generally buy put options with a strike price lower than the current price of the stock. This will not provide complete downside protection. However, most investors are willing to accept limited downside risk in order to purchase options with a lower premium. This is quite similar to paying a lower insurance premium by raising your deductible.
If you decide to buy at-the-money puts instead, the premium will be higher. Though this might reduce your losses if your stock drops significantly, it could result in a much larger loss if the stock remains stable and the puts expire worthless.
To determine whether buying protective puts makes sense or not, consider how low you think the stock might drop. In our example, you would only be better off buying the puts, which are 2 points out of the money, if the stock dropped to $68 or lower. Because you paid $72 for the stock and $2 for the puts, your total per-share basis is $74. If the stock drops to $68, you could exercise your puts and sell the stock for $70, sustaining a 4-point loss.
On the other hand, if the stock stays above $68, you would be better off not having spent the money for the puts. Because your basis is $72 on the stock purchase alone, the stock would need to drop at least 4 points (down to $68) before you would lose enough to offset the cost of buying the protective puts.
If we put the combined strategy numbers on a graph, you can see that the break-even price is $74, and the loss is capped at $4,000 for all prices below $70. You can also see that even though the downside loss is 2 points initially, losses are capped at 4 points below $70, all the way to zero, until the option expires. The upside potential is still unlimited, but will always be $2,000 less than if you had not purchased the puts.
Note: Chart depicts strategy at expiration.
Keep in mind that at any time prior to expiration, if your puts go in the money (stock drops below the strike price), you can generally sell them for their current market value. You may then purchase more puts with a later expiration date if you prefer. Not having to sell your stock position is a key benefit of protective puts, unlike some other hedging strategies that don't utilize options.
Stop orders
Because protective puts have an up-front cost that is incurred even if the protection isn't needed, many investors hesitate to employ this strategy. This is an important consideration so let's look at a couple other protective strategies that can help limit losses but don't have any up-front costs.
Under the right circumstances, placing a sell stop or a sell stop/limit order can be equally effective in preventing losses in the event of a downturn in the price of your stock—but not always. The table below briefly compares the pros and cons of protective puts, stop orders and stop/limit orders.
Note: Because market conditions can vary widely, executions of stop orders may not always occur
at or near the stop price. Stop/limit orders, like other limit orders, may not execute at all under
certain circumstances.
Protective calls: Short stock position and long calls in equal quantity
Protective calls work essentially the same way as protective puts, except that the position you're trying to protect is a short stock position instead of a long stock position. Additionally, the option you purchase is a call option, not a put option.
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It's generally unwise to maintain a short stock position if you think the long-term outlook for the stock is bullish. Therefore, you would typically only use protective calls if you felt that your short stock position might trend upward in the short term but that the long-term outlook was still unfavorable. Similar to protective puts, protective calls are like an insurance policy on a short stock position.
To illustrate, assume you are short 1,000 shares of XYZ stock at $72. If you do nothing and the stock suddenly jumps up to $90, your loss would be $18,000.
However, if you bought an "insurance policy" in the form of 10 XYZ June call options with a strike price of $75, at a price of $2, you could exercise your calls and close out your short stock position at $75. If you did this, the $2,000 premium you paid for your protective call options would be your "insurance premium," and the 3 points you lost on your stock (since you went short at $72 and closed it for $75) would be your "deductible." Overall, your loss would be about $5,000—$3,000 (the amount you lost on the stock) and $2,000 in premium (the amount you paid for the calls).
If, on the other hand, the stock remained below $75 by the June expiration, your calls would expire worthless, and the $2,000 you paid for them would be lost.
As with protective puts, you don't have to exercise your call options just because they have gone in the money. Most of the time, you can simply sell the calls at their appreciated value. Doing so would result in virtually the same profit-and-loss characteristics as exercising them. However, retaining the short stock position could result in further losses if the stock price continued to rise.
When establishing a protective call position, investors generally buy call options with a strike price higher than the current price of the stock. As with protective puts, this won't guarantee complete upside protection, but most investors are willing to accept some upside risk in order to purchase options with a lower premium. This is similar to paying a lower insurance premium, with a higher deductible. If you decide to buy at-the-money calls instead, the premium will be higher, resulting in a potentially smaller loss if the stock rises sharply, but a larger loss if the stock remains stable and the calls expire worthless.
In this particular example, you would only be better off buying the calls—which are 3 points out of the money—if the stock increases to $77 or more. Because you shorted the stock at $72, and paid $2 for the calls, your combined basis is $70. If the stock goes up to $77, you could exercise your calls and close out your short position for $75, sustaining a maximum 5-point loss.
If the stock didn't exceed $77 by the June option expiration, you would be better off not having spent the money for the calls. Because your basis is $72 on the stock sale alone, it would need to increase at least 5 points (up to $77) before you would lose more than if you had bought the protective calls.
Remember, you aren't required to exercise your calls if they go in the money (stock rises above the strike price). At any time prior to expiration, your calls could usually be sold at their market value, which at expiration would usually offset the amount the stock has increased above the strike price. If the stock rises to $77, the calls could probably be sold at about $2 prior to expiration. You could then purchase more calls with a later expiration date if you like.
If we put this strategy on the graph we used previously, you can see that the break-even price is $70, and the loss is capped at $5,000 for all prices above $75. You can also see that even though the upside loss is 2 points initially, losses are capped at 5 points above $75, regardless of how high the stock goes. The downside potential is still good all the way to zero, but will always be $2,000 less than if you had not purchased the protective calls.
Note: Chart depicts strategy at expiration.
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Because all investment strategies involve a certain amount of risk, let's conclude with a few precautionary points regarding protective puts and protective calls.
- These strategies will usually limit your profit potential if a stock moves substantially in your favor.
- While these strategies limit risk significantly, they cannot eliminate it entirely.
- Losses are generally limited to the premium you paid for the option plus the amount that option is out of the money.
- Anytime you purchase a long option, you have acquired the right, but not the obligation, to exercise your option to purchase or sell a stock at the strike price. If you choose not to exercise an in-the-money option, you will generally have the ability to close out that option in the market at any time prior to expiration.
- Because long options lose time value as expiration approaches, you may lose all of the money you invest, even if the price of the stock remains stable.
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Important Disclosures
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any option transaction.
Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
For the sake of simplicity, the examples in this presentation do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of strategies displayed. Please contact a tax advisor for the tax implications involved in these strategies.
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http://www.schwab.com/public/schwab/research_strategies/market_insight/investing_strategies/options/protective_puts_and_protective_calls.html?cmsid=P-2671734&lvl1=research_strategies&lvl2=market_insight
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