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Investors can take advantage of low current volatility in the stock market by purchasing deep out of the money put options on stocks to hedge their exposure to financial turmoil. Not to rain on the market's parade, but one must always be ready for a significant drop in stock prices, which does happen occasionally.

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 were net sellers over the past six months. This bearish sign is consistent with 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 bad news to surface and be reflected in stock prices and volatility. All the stocks which met the criteria have markets for January 2014 puts.

Generating a List of Deep out of the Money Put Candidates

Here is a list of stocks which met the criteria:

Company

Ticker

Industry

Altman Z-score

Jan-14 Put Strike

Jan-14 Put Ask*

Max Put Payout

Consolidated Edison

ED

Electric Utilities

0.88

30.00

0.25

120.0

NextEra Energy

NEE

Electric Utilities

1.04

35.00

0.45

77.8

Verizon

VZ

Telecom Services

1.17

20.00

0.28

71.4

Duke Energy

DUK

Electric Utilities

1.10

10.00

0.15

66.7

General Electric

GE

Diversified

1.20

5.00

0.08

62.5

American Electric Power

AEP

Electric Utilities

0.93

23.00

0.40

57.5

Comcast

CMCSA

CATV Systems

1.32

15.00

0.32

46.9

Energy Transfer Equity

ETE

Oil & Gas Pipelines

0.70

25.00

0.55

45.5

CenturyLink

CTL

Telecom Services

0.94

20.00

0.45

44.4

CBS

CBS

Broadcasting - TV

0.39

13.00

0.30

43.3

Time Warner

TWX

Entertainment

-0.45

18.00

0.44

40.9

PPL

PPL

Electric Utilities

1.08

20.00

0.60

33.3

Ashland

ASH

Chemicals - Major Diversified

1.52

25.00

0.80

31.3

Virgin Media,

VMED

CATV Systems

1.60

18.00

0.65

27.7

Transocean Ltd.

RIG

Oil & Gas Drilling & Exploration

0.50

20.00

0.77

26.0

Alcoa

AA

Aluminum

1.40

5.00

0.20

25.0

Owens Corning

OC

General Building Materials

1.67

13.00

0.55

23.6

Chesapeake Energy

CHK

Independent Oil & Gas

0.86

2.00

0.09

22.2

Dunkin' Brands Group

DNKN

Restaurants

1.56

17.50

0.90

19.4

Plains Exploration & Production

PXP

Independent Oil & Gas

0.95

15.00

0.82

18.3

Wyndham Worldwide

WYN

Lodging

1.48

25.00

1.65

15.2

HCA Holdings

HCA

Hospitals

1.73

18.00

1.20

15.0

Boston Scientific

BSX

Medical Appliances & Equipment

1.35

4.00

0.29

13.8

JetBlue Airways

JBLU

Regional Airlines

1.08

2.00

0.15

13.3

Atlas Energy

ATLS

Gas Utilities

1.07

20.00

1.70

11.8

Liberty Global

LBTYA

CATV Systems

0.54

50.00

4.72

10.6

Micron Technology

MU

Semiconductor- Memory Chips

1.77

3.00

0.33

9.1

SandRidge Energy

SD

Oil & Gas Drilling & Exploration

0.59

5.00

0.70

7.1

*The last trade price of an option was used in place of the ask if it was greater than the ask. Substitutions like this were made to avoid stale prices and keep estimates for put costs conservative.

Buying a diversified mix of these January 2014 puts is an attractive way to hedge for your long portfolio. In particular, the puts at the top of this list have very high strike price-to-premium ratios, which afford the most notional value per dollar for put buyers. Stocks near the bottom of the list afford little downside protection per dollar spent on puts. Puts with strike-to-premium ratios over 50 are unusual and worth considering.

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.

Source: Deep Out Of The Money Puts To Buy For Portfolio Insurance