Chapter lll - LONG STOCK PART 1 [Protective Put]

INTRO

Purchasing a stock and holding it for the long term is the most prevalent kind of investing. Assume you are optimistic on eBay and purchase 100 shares of stock. You profit $1 on each share for every $1 gain in the stock price. Because EBAY may continue to rise, the potential reward is infinite, but the maximum loss is theoretically restricted to the stock price because EBAY can never fall below $0. The risk/reward profile of buying EBAY for $100 is shown in Figure 3.1.

Because options are derivatives whose value is determined by the underlying stock's movement, they may be used in combination with a long stock position to lock in a profit, hedge or minimize a possible loss, or generate more profit or leverage. This chapter discusses how to change a long stock position using calls, puts, and different combinations of the two. As usual, appropriate risk management is the aim. Whatever adjustments you make, bear in mind the updated risk/reward profile and how it aligns with your expectations of the underlying stock's performance. No adjustment is superior to another; each adjustment is best suited to certain conditions. The goal is not to make a change for the sake of trading. Each feasible adjustment serves an investing goal, and you must understand each adjustment's purpose in order to make the best investment option.

PROTECTIVE PUT

You may purchase options to protect against any negative movement in the stock until expiry at the same time you launch a long stock position. Because a put offers the holder the right to sell 100 shares of stock at a certain strike price, the put protects the holder against any decrease in the stock's price below that strike. The two primary components of every insurance policy are the premium and the deductible.

The premium is the cost of the insurance, and the deductible is the amount of damage you will incur before the insurance policy's protection kicks in.

With puts, the premium is the cost of the option, and the deductible is determined by the strike price you choose in relation to the stock price.

Assume you paid $100 for 100 shares of EBAY. To protect yourself against a decline in the price of EBAY, you might buy a protective put along with the stock. The strike price you choose will be determined by the insurance policy's premium and deductible. Assume that EBAY holds options with the following expiry dates and pricing with 3 months to expiration. Although you are long EBAY, you are worried about short-term market weakness and an approaching earnings statement and desire to get insurance against a dip in the stock price:

To hedge EBAY at $100, buy one $100 Put for $4.60. This put gives you the opportunity to sell EBAY at $100 at any moment until expiry, allowing you to protect yourself against a dip in the EBAY price. The premium for this insurance policy is $4.60, which is the amount paid for the put. The deductible represents the maximum loss suffered as a result of the hedge. If EBAY is at $100 when the put expires, it will be worthless, with a maximum loss of $4.60. The maximum loss on the investment is $4.60 at any price less than $100. For example, if EBAY is trading at $97, you may sell the stock at $100 to break even on the trade. You will, however, lose the premium paid for the put, resulting in a $4.60 loss. Because that is the maximum you may lose, the deductible on this insurance policy is likewise $4.60. To demonstrate the possible profit and loss of EBAY with the protective put, the results for the combined position at various prices at expiry (P/L denotes profit or loss) are as follows:

This combined position has a breakeven value of $104.60. At that price, the $4.60 gain on EBAY covers the $4.60 loss on the put. Because of the premium, adding the protective put increases the breakeven point. The insurance was paid for. The breakeven point is equal to the put premium on the stock price. You have given up part of the upward benefit in exchange for reducing your loss on the downside by adding the protective put. In Figure 3.2, compare the risk/reward graphs of the protective put at $100 paired with stock to the direct purchase of EBAY.

As with any insurance policy, the deductible and premium must be balanced. If you raise your premium payment, the deductible drops. By employing an in-the-money protective put to hedge the long stock position, you may boost the EBAY insurance premium and so lower the deductible. The EBAY $105 Put is now quoted at an option premium of $8.20. The maximum loss is now $3.20 when we pay a higher premium. For instance, if EBAY's stock price drops from $100 to $95 at expiry, a $3.20 loss would result after accounting for the $1.80 gain on the put option and the $5.00 loss on the stock. If EBAY's price is $105 at expiry, a loss of $8.20 on the put would be offset by a gain of $5.00 on the stock, for a net loss of $3.20. As a result, although an ITM put costs more than an ATM put ($8.20 vs. $4.60), the deductible, or maximum loss, is smaller ($3.20 vs. $4.60). If you choose an OTM put, your premium will be cheaper, but your deductible will be substantially greater. You restrict your maximum loss to $7.30 by acquiring the EBAY $95 Put for $2.30. The put's protection does not commence until EBAY falls below $95. Figure 3.3 examines the various risk/reward profiles on the combined EBAY stock and protective put at various strike prices.

The strike price you choose is determined by your risk tolerance, the amount of protection you want, and your capacity to pay. If you believe there is a chance of a price shock on EBAY in the near future, you may desire the finest insurance available, that is, the one with the lowest deductible. As a result, you would choose the ITM put to hedge your position. If you believe the possibility of a price decline is modest but still want some protection, consider the OTM put. As shown in Figure 3.3, adjusting the strike price affects both the maximum loss and the breakeven point of the position. The breakeven threshold is lower the smaller the premium. As a result, the strike price you choose when buying a put depends on whether you foresee a major or minor fluctuation in the stock price and how much protection you need.

STOCK MOVES HIGHER

After a stock has risen upward, a protective put may be placed to it. If you are concerned about a price reversal after a stock has moved upward but still want to hold the stock, a protective put may ensure a minimum profit while hedging against any downward movement. More crucially, the protective put permits you to benefit from any subsequent upward movement in the stock.

Considering the same EBAY stock was acquired at $100 and has now climbed to $110, the following put pricing would apply:

To hedge against a probable reduction in EBAY's price, add the EBAY $110 Put for $4.60 to the position. The $110 Put ensures that you may sell EBAY at $110 until expiry, regardless of how much the stock price falls. The guaranteed profit is the difference between the strike price and the purchase price ($110 - $100 = $10.00) less the put premium ($10.00 - $4.60 = $5.40). By adding the put to your long stock position, you have guaranteed a minimum profit of $5.40 until expiry, with the possibility for a larger profit if EBAY continues to rise. When you use an ATM put, you continue to benefit as the stock climbs over the strike price. The change has changed a dangerous transaction of owning 100 shares of EBAY into a risk-free investment till the put expires. Figure 3.4 contrasts the long position in EBAY with the risk/reward profile after the protection put at $110 is added.

By picking a larger strike price, you may enhance the assured profit. If you utilize the EBAY $120 Put at $12.20, your guaranteed minimum profit is $120 - $100 - $12.20 = $7.80.

The downside of selecting a higher strike is that the stock must make a larger upward move before the total profit reaches the guaranteed minimum. Using the $120 strike price, for example, we can see that the position will not earn more than $7.80 until the stock climbs over $120, as shown in the following (P/L denotes profit or loss):

Unless the stock climbs over the strike price, the position makes no more than the minimal profit. As a result, employing a higher strike for improved minimum profit necessitates a larger move.

in the underlying stock to earn more than the minimal profit. This is a negative hedge since it provides for a larger return on the downside and is employed when the stock is not projected to rise much.

If you want to lock in a profit but believe that EBAY will rise much higher than $110, then choosing the strike for the protective put is critical. With an at-the-money put, you may still benefit from the stock's rise, albeit the minimum profit is reduced. You gain a greater minimum profit by raising the strike price, but you need a larger increase in the stock price to earn more than the locked-in profit.

If you pick an out-of-the-money strike price, your assured profit will be reduced. However, since the stock is trading above the strike price, the trade is already worth more than the minimum profit. The guaranteed minimum profit on the EBAY $105 Put is $105 - $100. $2.30 = $2.70. However, at $110, the entire position profits $7.70 ($10 profit in stock - $2.30 premium of put) vs a profit of $5.40 if the ATM $110 Put is used. This is a more bullish hedge since it provides for more upside reward while still securing a risk-free benefit. The risk/reward profile of your updated EBAY position utilizing the ITM, ATM, and OTM protective puts is shown in Figure 3.5.

STOCK MOVES LOWER

Adding a protective put to a stock position that has increased in value is a simple modification. What happens if the stock price falls?

If the stock is down and you believe it will continue to decline, reduce your losses and sell the shares. However, if the stock has declined but you believe it might recover and you are investing for the long term, you may be motivated to hang on to it. If you are concerned about the stock continuing to decline, you may add a protective put to limit your loss on the stock if it continues to fall. If the stock rises, you can still profit from it, but if it falls further, your put will hedge your loss.

It may seem odd to use options to lock in a loss rather than a profit, but risk management often requires taking a loss while keeping the position from losing any more money while giving it a chance to recover.

Assume you purchased EBAY for $100, but it has now decreased to $95. If you believe that the price decline is transitory and that it will return, but you are concerned that it may fall further, a protective put will enable you to continue to own the stock while preventing additional losses (Figure 3.6). If you bought a 2-month EBAY $95 Put for $3.00, no matter how much the stock falls in the following two months, the protective option would restrict your loss to $8.00 when you exercised it ($5.00 loss on stock + $3.00 premium of put). If EBAY continues to rise, you may still profit from it.

The only disadvantage of including the put is that the inclusion of the insurance has lifted your breakeven point from $100 to $103 owing to the $95 put charge. This is the cost of obtaining insurance. The advantage is that you may rest for two months and hope that EBAY will rebound without fear of losing additional money. If EBAY falls, you are hedged, and if it reverses and rises, you continue to benefit from the endless profit potential. You have successfully limited your loss to 8% ($8.00 loss on a $100 stock), which is excellent risk management.

Simply adjust the strike price to change the maximum loss amount. The last example made use of an ATM put. If you change the strike to a deep ITM put, such as a 2-month EBAY $100 Put at $7.50, the premium goes up, but your locked-in loss is reduced to 7.5% ($7.50 premium to sell shares at original price of $100). Of course, the higher advantage of a smaller restricted loss has a cost. The disadvantage is that you've boosted your breakeven target to $107.50, requiring an even stronger rise in EBAY to repay your insurance costs. Because ATM puts have a superior risk/reward profile, using a deep ITM put is not recommended.

Choosing a somewhat OTM put is another means of hedging and locking in a maximum loss should EBAY continue to decrease. If you choose a 2-month EBAY $90 Put that was selling at $1.75, your maximum loss was increased to $11.75 ($10.00 loss on stock + $1.75 premium). Your maximum loss limit is more than the $8.00 incurred by utilizing ATM puts. The rise in your breakeven point relative to the initial purchase price ($101.75) has not been that significant. Therefore, if you are unwilling to add too much to your breakeven point and are prepared to endure a little greater loss, OTM puts are advised (Figure 3.7).

However, you must consider your underlying assumptions on EBAY's future movement while determining the optimal maximum loss versus breakeven point. If you are still very positive on EBAY but desire to be cautious, you anticipate the stock to make a nice turnaround and rise throughout the term of the put. You do not want to increase your breakeven point too much since you want to participate in eBay's increasing trend. In such a circumstance, an OTM protective put may be the best option. Using an out-of-the-money put still provides a loss hedge, but only marginally boosts your breakeven point. If your concerns about a further decline in the price of EBAY are significant, but you are hesitant to sell the stock since a rebound is still conceivable, utilizing ATM puts will lock in a reduced loss. You may wish to minimize your losses as much as possible while still profiting if EBAY recovers.

It may seem strange to acquire a put and then want the stock to rise, but keep in mind that your primary investment, from which you want to benefit, is 100 shares of EBAY, not the put. The put is only a hedging supplement to your original position, and while adjusting trades, you should never lose sight of your primary investing aim. You may be required to take a loss on the put in exchange for protection, but that is the purpose of insurance.