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By Richard Bloch

Chuck Carnevale wrote an interesting post suggesting that “Stop Losses Are for Losers: See Green Mountain, Garmin.”

It’s an engaging read as it’s sort of double entendre on the meaning of “loser.” Setting a stop loss order on a stock that goes down helps protect against “loser” stocks. But if you’re stopped out on a stock that ends up winning, well than you’re the “loser.”

Chuck cited examples of being stopped out of an investment in Green Mountain Coffee Roasters (NASDAQ:GMCR) in 2008, only to see the stock rise by more than 470% in the next 2-1/2 years.

But he also showed an example of being stopped out of Garmin (NASDAQ:GRMN) in 2007 before it began its journey from more than $100 per share to a recent price of around $35.

I should point out that Chuck makes a good point about carefully evaluating a company’s fundamentals and ignoring short-term price movements if you’re a long-term investor. But we all make mistakes. The only question is how much they can cost us.

Here’s a look at the hypothetical performance of investing in both of these stocks using Chuck’s initial scenario:

[Click all to enlarge]

What a difference in performance! But a 10% stop would have been triggered within days of making either investment. That would have helped to protect you against further declines in Garmin, but would have prevented you from taking part in significant gains in Green Mountain Coffee.

As I looked over Chuck’s examples, I wondered if buying protective puts might have been worth the expense on either or both of these stocks.

Buying puts: Protecting gains, preventing losses

I will be the first to admit that going back to look at trades you “might have made” can be deceiving. Nevertheless, I made some assumptions about how an investor might have purchased puts instead of setting a stop loss order on both of these stocks.

To a certain extent, having a put option on a stock you own is a lot like setting a stop order. That’s because owning a put option gives you the right to sell a stock at the strike price of the option until it expires. True, it can add to your commission costs and, depending upon the strike price, there may be a substantial premium to pay ... but at least until the put option expires, you’re protected at the strike price of the put you own – without the need to set a stop on the stock.

So here are the assumptions I used in creating a hypothetical protective put buying strategy for both these stocks.

  1. Purchase puts with approximately six months until expiration at a strike price about 10% below the original investment level.
  2. At the close of each expiration (roughly every six months), replace any expiring puts with new ones at a strike price that’s either 10% below the original investment level or 10% below the market price of the stock (whichever is higher).

This is very simplistic. There could easily have been better opportunities to manage these positions instead of simply taking action every six months. But even so, here’s how this admittedly simplistic strategy would have worked out (a list of the trades for this strategy appears near the end of this post):

The grey lines on the charts show hypothetical results from simply buying the stock (the same as Chuck’s scenario in the first two charts of this post).

The dashed red lines represent the cumulative total investment in both the stock and purchasing puts (including commissions). The green lines show the minimum value of the total investment at any given time based on the value of the stock and puts owned.

The charts show that buying puts can be expensive and put a real dent in your returns – especially for stocks like these, which can have high implied volatilities. It also requires that you pay attention to expiration dates because any “floor” on your investment that comes from owning puts disappears when those puts expire.

In the case of Green Mountain, you would have almost tripled your cost basis. As for Garmin, it seems almost comical to continue buying puts over the years on a stock that plunged so rapidly and showed no signs of rebounding. But note that with the puts in place, you could have gotten out of Garmin at any time with a loss far less than if you just owned the stock.

Putting stability into your portfolio

Viewed purely in dollars and cents, buying puts probably wasn’t the best strategy for these two stocks. But when you look at those green lines you can see there’s a certain level of stability in the risk you’re taking on at any given time. A portfolio of positions like these can be less volatile overall than owning stock alone.

And sure, while Green Mountain did perform impressively, there were various times when the stock was down 30% or even 40% from previous highs.

Here’s a list of the hypothetical trades shown on the charts. I used the best offer for purchasing puts and the best bid for selling puts with any value at expiration (although that was never the case with Green Mountain).

Garmin put buying strategy

Date Stock Price Transaction Price Credit or Debit* Notes
09/28/07 119.40 Buy 100 shares 119.40 ($11,945)
09/28/07 119.40 Buy 1 Apr. 2008 110put 11.70 ($1,176)
04/18/08 45.46 Sell 1 Apr.2008 110 put 64.40 $6,434
04/18/08 45.46 Buy 1 Oct. 2008 110 put 64.90 ($6,496)
10/17/08 24.32 Sell 1 Oct. 2008 110 put 84.50 $8,444
10/17/08 24.32 Buy 2 Apr. 2009 55 puts 33.00 ($6,600) 1
04/17/09 22.00 Sell 2 Apr. 2009 55 puts 32.80 $6,553
04/17/09 22.00 Buy 3 Oct. 2009 35 puts 13.60 ($4,087) 2
10/16/09 37.54 Buy 3 Apr. 2010 35 puts 4.30 ($1,297)
04/16/10 36.12 Buy 3 Oct. 2010 35 puts 4.00 ($1,207)
10/15/10 31.40 Sell 3 Oct. 2010 35 puts 3.50 $1,043
10/15/10 31.40 Buy 3 Apr. 2011 35 puts 6.05 ($1,822)
03/04/11 34.77 Sell 3 Apr. 2011 35 puts 1.70 $503
03/04/11 34.77 Buy 3 Oct. 2011 35 puts 5.25 ($1,582)
Total ($13,235)

* Credit amounts have been reduced to account for commission costs of 4.95 per trade plus 65 cents per option contract. Debit amounts reflect the addition of commission costs at the same commission rate.

Notes:

[1] No 110 puts available so substituted 2 puts at 55 strike price

[2] No 55 puts available so substituted 3 puts at 35 strike price

Green Mountain Coffee Roasters put buying strategy

Date Stock Price Transaction Price Credit or Debit* Notes
09/30/08 39.34 Buy 200 shares 39.34 ($7,873)
09/30/08 39.34 Buy 2 Mar. 2009 35 puts 5.50 ($1,107)
03/20/09 45.24 Buy 2 Sep. 2009 40 puts 6.20 ($1,247)
09/18/09 68.59 Buy 3 Mar. 2010 60 puts 7.30 ($2,197) 1
03/19/10 93.90 Buy 3 Sep. 2010 85 puts 7.20 ($2,167)
09/17/10 35.43 Buy 9 Mar. 2011 32 puts 3.40 ($3,071) 2
03/04/11 41.75 Buy 9 Sep. 2011 38 puts 4.85 ($4,376)
Total ($22,038)

* Credit amounts have been reduced to account for commission costs of 4.95 per trade plus 65 cents per option contract. Debit amounts reflect the addition of commission costs at the same commission rate.

Notes:

[1] Stock split 3:2 in June 2009, requiring purchase of 3 puts

[2] Stock split 3:1 in May 2010, requiring purchase of 9 puts

Some final thoughts

If you’re confident that the stock you’re buying represents excellent value and market fluctuations don’t concern you enough to set a stop order, then buying puts could be too expensive and cumbersome to consider. And managing options positions can add a high level of complexity that may not be suitable for all investors.

But if you are inclined to set stop orders – at least initially – you might consider put options instead. They can help keep you in a stock that you might otherwise get stopped out of.

So just like stop loss orders, puts are for losers – a great way to help protect yourself from “loser” stocks and avoid being the “loser” in missing out on a stock like Green Mountain Coffee Roasters.