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Deep out of the Money Put Options as Portfolio Insurance

Investing in the stock market is treacherous because there are occasional price declines that demolish shareholder value. Investors can hedge their exposure to financial turmoil by purchasing deep out of the money put options on stocks.

Deep out of the money put options have no intrinsic value, and will expire worthless unless there is a dramatic price decline in a stock. Thus, they tend to be somewhat inexpensive, but are unlikely to provide any return. Put buyers must carefully select stocks which score poorly according to tests of financial health since the vast majority of out-of-the-money puts expire worthless.

The following criteria were used to select the most cost-effective puts:

1) The stocks score as potentially distressed according to the Altman Z-Score.*

2) Insiders are selling shares over the past six months. This bearish sign signals a lack of confidence.

3) The stocks have lower than average volatility. Essentially, the more volatile the stock is, the more likely the possibility of its price moving dramatically. Unfortunately, volatility is a major determinant in the pricing of options, so this metric alone wouldn’t help identify bargain puts. In short: buying puts on higher volatility stocks would cost more.

4) Long-dated put options are sold for the stocks. Maturities between one and two years will allow for any bad news to surface and be reflected in stock prices.

Generating a List of Deep out of the Money Put Candidates

Here is a list of stocks which met the criteria:

Ticker

Company

Altman Z-Score

P/E

P/B

Insider Transactions

(NYSE:AA)

Alcoa, Inc.

1.52

9.74

0.65

-15.8%

(NYSE:AEP)

American Electric Power Co., Inc.

0.97

12.51

1.34

-9.4%

(NYSE:CBS)

CBS Corporation

0.07

15.79

1.84

-7.1%

(NYSE:CCI)

Crown Castle International Corp.

1.02

91.94

4.9

-3.6%

(NYSE:CSC)

Computer Sciences Corporation

1.56

0

0.78

-2.8%

(NYSE:CVC)

Cablevision Systems Corporation

0.82

14.85

0

-8.2%

(EP)

El Paso Corp.

0.80

871.33

4.61

-20.6%

(NASDAQ:EQIX)

Equinix, Inc.

1.30

62.83

2.46

-12.0%

(NYSE:F)

Ford Motor Co.

1.31

7.05

7.51

-4.2%

(NYSE:IPG)

The Interpublic Group of Companies

1.16

12.15

2.01

-4.2%

(NYSE:NEE)

NextEra Energy, Inc.

0.99

16.23

1.67

-6.6%

(NYSE:NFX)

Newfield Exploration Co.

1.54

10.46

1.34

-3.1%

(NYSE:PPL)

PPL Corporation

0.99

10.8

1.52

-10.3%

(NYSE:RCL)

Royal Caribbean Cruises Ltd.

1.10

9.11

0.66

-2.2%

(NASDAQ:SIRI)

SIRIUS XM Radio Inc.

-0.73

66.67

13.33

-19.1%

(NYSE:SO)

Southern Company

1.39

18.3

2.05

-34.9%

(NYSE:TIN)

Temple-Inland Inc.

1.59

51.16

3.6

-3.0%

(NYSE:TWX)

Time Warner Inc.

-0.61

13.84

1.19

-3.8%

(NASDAQ:VMED)

Virgin Media, Inc.

0.40

75.62

5.14

-65.5%

(NASDAQ:WCRX)

Warner Chilcott plc

1.23

42.16

106.8

-87.4%

(NYSE:WYN)

Wyndham Worldwide Corporation

1.36

14.53

2.4

-4.3%

Buying a diversified mix of puts on these firms which have long-dated maturities is a savvy hedge for your long portfolio.

It is prudent to note that there is no way to tell the future, and that many of these firms are currently healthy and will remain so in the future. This is a list of put candidates based on a credit scoring model, and by no means is a divination or a guarantee about future events.

Disclaimer: This article was written to provide investor information and education, and should not be construed as a guarantee or investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing. I repeat: this research does NOT constitute a guarantee.

*The Altman Z-Score is a measure of bankruptcy risk that is not based on stock price volatility. This score places companies into three groups: “safe” (Z-score > 2.99), “grey” (Z-score between 2.99 and 1.81), and “distressed” (Z-score < 1.81), and is surprisingly useful for identifying bankruptcy risk in the coming year. This method of segmenting companies uses of fundamental (financial statement) data and market capitalization only, not on price volatility. Beyond credit risk prediction, companies with higher Z-scores have historically outperformed companies with lower Z-scores, in aggregate. One sector has not been accurately modeled: Altman’s Z-score has not accurately predicted the bankruptcy risk of financial companies.

“Distressed” was a label coined by researchers, and should not be taken to mean that any company is bankrupt or in default on the basis of this calculation alone. Credit scoring is not fate, only prediction based on relative past performance of companies grouped by key variables. Time will tell.

Volatility has be incorporated into a credit scoring to improve accuracy and extend it to financial companies, but this would reduce the value of a fundamentals-only model for indicating attractively-priced put options.

Source: A Few Ideas For Deep In The Money Puts