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:
Automatic Data Processing
American Electric Power
Energy Transfer Equity
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.
*Read the article disclaimer.