How to Dollar Cost Average more intelligently using Put options - PART l

What most long term, passive investors do

The most common form of doing an investment is to long (buy) a stock and hold it for the long haul. This strategy is suitable for very passive investors who do not have the time and energy to get into the details but still want to let time and invested monies do the legwork in the long run.

For example, say you are bullish on $BABA and decided to buy 100 shares of the stock. For each $1 increase in the price of the stock, you make $1 profit per share. The maximum reward is unlimited because the stock can keep rising higher, while the maximum loss is theoretically limited to the price of the stock (which is $100 in this case) because $BABA can go no lower than $0. Your risk reward profile if you simply buy the stock is shown below.

As a regular long term investor, if you do not know how to effectively and smartly use options to help hedge your DCA, this is pretty much your risk reward profile.

Protective Put

Before we talk about how to use the tool, let's first understand what the tool is and why it can be used.

Options (the tool) are derivatives which value is based on the movement of the underlying stock. It can be used in conjunction with a long stock position to lock in a profit, hedge or limit a potential loss. This article covers the adjustments that be made to a long stock position using a put (calls will not be discussed here). The goal, as always, is proper risk management, keeping in mind what the adjusted risk/reward profile is and how it meshes with your expectations of the movement of the underlying stock. At the end, it all boils down to your goals...and knowing what is out there helps you make a better decision.

Say you are long 100 shares of $BABA at $95. To hedge against the drop in the price of $BABA, you could purchase a protective put in conjunction with the purchase of the shares. Which strike price you choose will depend on the premium and the deductible of the "insurance policy" that is needed. Buying a put option is seen as taking an "insurance policy" because you pay a premium to protect yourself against any downward movement of the stock until expiration. Because the buy put gives the holder the right to sell away 100 shares at the pre-determined strike price, the put hedges against any decline in the price of the stock below the strike.

Let's take an example, and view the option premiums below with 3 months to expiration. Although you are long $BABA, you are concerned about the short-term weakness in the market and any other bearish reasons and wish to acquire insurance against a drop in the price of the stock.

$BABA @ $95

Option Put prices as follows (3 months DTE):

$BABA 90 Put @ $4.00

$BABA 95 Put @ 6.00

$BABA 100 Put @ $10.00

If you wish to hedge $BABA at $95, you can purchase 1 x $95 Put for $6.00. This put will now give you the right to sell $BABA at $95 anytime within the three months time frame and therefore hedges against a drop in $BABA price. If $BABA is at $95 at expiration, your put will expire worthless and you will lose $6.00. For any price below $95, the max loss is capped at $6.00. For example, if $BABA is at $89, you could exercise the put, or close out the position by selling it back, and breakeven on the stock position.

To illustrate the potential profit and loss of $BABA with the protective put, the following gives the results for the combined position at different prices at expiration. (PnL represents Profit or Loss):

$BABA	STOCK PNL ($)	PUT PNL ($)	POSITION PNL ($)
80	-15.00	+9.00	-6.00
85	-10.00	+4.00	-6.00
90	-5.00	-1.00	-6.00
95	0.00	-6.00	-6.00
100	+5.00	-6.00	-1.00
105	+10.00	-6.00	+4.00
110	+15.00	-6.00	+9.00

The breakeven point for this combined position is $101. At the this exact price, the gain from the price of stock of $6.00 offsets the loss on the put of $6.00. Adding the protective put raises the breakeven point due to the premium paid for the insurance. The breakeven point is equal to the stock price + put premium. (If you want are new and want to learn more about these concepts, please check out here to engage me to see how I can help accelerate your progress).

You have essentially given up some of the upside profit in exchange for limiting your loss on the downside. Compare the risk/reward figures on the table above for that of a pure long stock (column 2) versus that of a combined position (column 4).

Why this pairs so well with DCA is this -- you limit your losses to a level that is more comfortable, while knowing that if the stock start to eventually go higher (that's what you expected right? else why would you DCA?), you are still well poised to capitalize on the profits. And I am sure for seasoned investors, there is always a saying to not time the market and go in in tranches when you DCA. For the most part, you could very well be DCA-ing in tranches as the stocks continues to move lower and lower and lower. If you hedged your position with the put option in this situation, you can actually rest easy because you know you risk is capped and you are well protected in the mid term. You can even take profits from the put option the moment you start to see the trend of the stock price reversing, which means a double gain:

The gain from the profits from your put options, as well as a gain from the recovery of your stock price.

Golden Question: Which strike price to choose?

I get this ALOT. Very common question from beginners. In fact, even seasoned folks in the markets for years might struggle with this.

The key thing to realize and understand here is that there is always a trade off between the breakeven price and the premium. The breakeven price decreases if you increase the premium paid. You can decrease the breakeven by buying a more expensive premium, by using an in-the-money protective put to hedge the long stock position. Using the Option chain above, you can purchase a $100 Put for $10.00. Although the premium paid is higher, the maximum loss is now $5.00. For example, if $BABA is at $85 at expiration, the $15.00 loss on the stock is offset by the $10.00 gain on the put for the a net loss of $5.00. Therefore, although you pay a higher premium for the ITM put vs the ATM put ($10 vs $6), the max loss is lower ($5.00 vs $6.00).

If you select an OTM put, the premium paid is lower, but the breakeven point is also much lower. By purchasing a $BABA $90 Put for $4.00, you limit your max loss at $9.00. The protection of the put does not begin until $BABA starts to move below $90.

Quick summary, for $BABA 100 shares bought at $95 and stock drops to $85 scenario:

- OTM 90 Put --> premium cheapest at $4.00, max loss greatest at $9.00

- ATM 95 Put --> premium at $6.00, max loss at $6.00

- ITM 100 Put --> premium at $10.00, lowest max loss at $5.00

Therefore the strike price you choose depends on your level of risk tolerance, how much protection you wish to have, and your ability to pay. If you feel like $BABA has the potential for a price shock in the short term, then you want to get the one with the lowest max loss, which is the ITM put. If you feel like the likelihood of a price drop is low but still want some protection, then you might opt for the OTM put. Changing the strike prices not only changes the max loss, it also adjusts the breakeven points. The lower the premium, the lower the breakeven point.

Summary

In short, knowing how to use put options can be a massive advantage for seasoned investors who intend to DCA, but don't want to bear the risk of a stock going even further lower, or even to $0. We have seen cases of stocks which dropped after a downturn and never returned back up. Hedging your DCA with put options will work tremendously well in this case to protect your portfolio. And if the stock eventually recovers, you stand to enjoy the continued upside of the stock.

Stay tuned on this same topic

What happens if the stock moves higher? To be continued in next post...