In this day of the high-powered leveraged options play, prophetic 'black box' technical indicators, and over-hyped quick income trading strategies, I'd like to bring the old dust and mothballs covered idea of married puts back out and consider something different.
While looking at an old idea, how about we put a new twist to it? We can look at Cooper (COO), which closed today at $85.53. Say we bought it near the close at $85.50. A traditional married put play might buy an out-of-the-money (OTM) July $80 put option for $2.25.
This is a net bullish position, meaning that we hope Cooper stock price will go up. The put option is merely an insurance policy, protecting the stock price in the near term should Cooper drop to less than $80 per share. Better than a stop order, the put is a legal and binding contract. Regardless of where Cooper opens, no matter what overseas country is in trouble or what domestic issues may be affecting the broad market, the $80 put option guarantees the right to sell Cooper at $80 a share.
Is that worth $2.25? A lot of folks might say yes. But I like to advance another idea. I'm going to suggest that instead of buying a put option that guarantees the right to sell Cooper at less than what it's currently trading, why not purchase a put option which guarantees that we can sell it for more? I'm suggesting buying an in-the-money (ITM) put as opposed to an out-of-the-money put.
Certainly this will cost more, but it will be a better investment if indeed Cooper's stock price goes in the wrong direction. The loss on the stock will be less because of the tighter rein that the higher put option has on the stock's price. Delta for the ITM put will be higher and it will respond faster during a decline.
Continuing with the insurance analogy, generally speaking, if you pay for your insurance month by month it is paid at a premium price. But if you pay for six months of coverage at a time, the broker traditionally offers a discount. This is no different in the options trading arena; if you want to get an insurance policy for your stock, buying an expiration date that's further out saves you money on a per month basis. The total price is more, but the monthly or daily cost is less.
The graph below illustrates the familiar hockey stick graph of a married put position for protecting the Cooper stock. A floor or maximum loss limit is provided by the put option, but unlimited upside potential if the stock advances. The expiration date of the put option determines the length of time the position is insured. For the OTM case, the time associated with the put option insurance is 51 days:
Source: PowerOptions Custom Spread Tool
Now let's contrast the OTM graph above with the ITM graph shown below in which we buy the same stock, but purchase a further-out in time (170 days) and higher-up strike price put option (90):
Source: PowerOptions Custom Spread Tool
Buying a $90 put option far out in time appears to provide better protection, for longer, at a bargain price if we consider the price per day. Let's look at the same information in a table format:
Put Strike and Month
Max Loss (from present) price of $85.53
Length of protection
Cost per DAY to protect
July 2012 $80
$758 (if stock goes to $80 or lower)
Nov 2012 $90
$503 (part of this put is guaranteed back)
By observing the levels of protection, what you get (and for how long) versus what you pay for, the longer expiration term of the put seems to be better value because the cost per day is considerably less. And by purchasing a put more ITM, the maximum risk has been reduced from 8.7% to 5.3%.
One might argue that the more you spend for your put option, the more you limit your profits. On the other hand, risk management is the single most important factor in investing. An investor needs to avoid a total loss in order to survive and still have money left to invest. In the long run, we always hope that our stock picks go up, but in case it doesn't, having the best protection on hand is well worth the price.
Summary of the advantages of the "New Twist" with ITM puts:
1. Longer protection period X3
2. Lower % Max. Risk of capital (-$250)
3. One third less cost /day for the protection
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