Buying Puts On Your Stocks: Less Volatility, But Is It Worth It?

Includes: AAPL, BB, NFLX
by: Richard Bloch
You can use options to do a lot of things: Speculate on price movements, take advantage of changing volatility, profit from time decay, etc.
But what about something simple – even old-fashioned – like buying insurance to protect long stock positions?
It’s pretty expensive – at least right now. A 10% out of the money put on Apple (NASDAQ:AAPL) that expires in 90 days costs about $18 as of Friday October 7. Back in early July, it only cost $8 for the same protection. (And that’s not just because Steve Jobs died; those options cost about the same in late September, adjusting for time decay).
But over the long-term is buying puts worth the expense? I decided to look at three stocks – Apple, Netflix (NASDAQ:NFLX), and RIM (RIMM) – and review a hypothetical put buying scenario assuming an initial investment back in January 2010,
Put Strategy Guidelines
I created a portfolio that included these three stocks, plus slightly out-of-the-money put options with a two-year shelf life (the January 2012s) and a system for “rolling up” those puts if the stock rose.
I decided on a ratio of 45%. In other words, if I could spend $450 and raise the “floor” on my investment by $1000, I’d do so.
Using LEAPS options that expire in two years probably isn’t ideal. They’re not very liquid and represent expensive insurance, but I didn’t want to add a “rolling out” component to my “rolling up” scenario. Just too many moving parts to analyze.
So let’s look at these three investments.
AAPL Results: Lower Returns, Lower Risk
Purchasing 100 shares of Apple in January 2010 would have cost $21,401. Adding a January 2012 200-strike put at $3,625 would have totaled $25,026. (None of my calculations accounts for commissions)
Here’s the results if I’d simply purchased the stock:

This chart shows the results if I would bought the puts and rolled them up based on my system:

The dashed purple line shows my cumulative investment in roiling up the puts. The green line representing the “floor.” In other words, owning a 410 put means the total position can’t be worth anything less than $41,000 (at least until the option expires). That’s the good news. The bad news? I raised my total cost basis by almost $100 per share.
It’s hypothetical analysis, of course, but I do feel like a hypothetical idiot for leaving so much hypothetical money on the table.
The thing about buying puts is that nobody wants to be the chump who owns them if the stock goes up. It eats into your returns.
But nobody wants to be the chump who doesn’t own them if the stock plunges. Now that can really eat into your returns.
With that in mind, let’s take a look at Netflix.
Netflix: Locking In Large Gains On A Big Plunge
Until this past July, Netflix was a better stock than Apple. From January 2010 through July 2011, Netflix was up five-fold while Apple still has yet to double its January 2010 price. But since July, Netflix plummeted by more than 60%.
Based on a purchase of 400 shares in January 2010 for $21,392, a Netflix stock-only position would still be profitable as this chart shows.

But compare that to what the return would have been had I also purchased four January 2012 45-strike puts for an additional $3,480 ($24,872 total) and then rolled them up over time as I did with the Apple example.

Compared to the stock alone, ratcheting up those puts to higher levels would have more than tripled my cost basis to more than $70,000. But I would have locked in a significant gain (a floor of $114,000) even if the stock hadn’t tanked.
There’s a lot to like about a guaranteed gain (until January 2012 anyway).
Will NFLX ever go up past my 285 put strike by January expiration? That seems highly doubtful, but I could always sell puts against my really deep-in-the-money puts (and sell calls against the stock for that matter).
(Oh, one minor detail: The reason the real value of the holdings is $450 less than the “floor” is because I’m using the bid price of these options. When they get really deep in the money, no investor will want them, so Mr. Market Maker is going to charge a premium if you want to get out of them. There may be ways around this, but that’s beyond the scope of this article).
RIMM: Getting In At The Top
Finally, I reviewed a hypothetical scenario of buying 300 shares of RIMM back in January 2010 for $19,779 against also adding three January 2012 60-strike puts for an additional $3,780.
A RIMM stock-only position would have turned out, well, grim.

As for the put strategy? The one good thing you can say about it is that it wasn’t very complicated. There was never any chance to roll up those puts because early January 2010 was pretty much the wrong time to invest in RIMM.

This one was a loser – even with put options. Yes, it’s dead money, but at least it wasn’t a catastrophic loss. The “floor” of this investment is less than the initial investment, so this almost certainly a locked in loss. But it’s not getting any deeper until the options expire.
Putting Puts To Work: Reducing Volatility
These charts show the net result of all three of these positions.

Yes, you do have to keep adding money to ratchet up the floor of your investment, but there are put-selling and call-selling strategies you might have used to reduce the overall cost of the puts over time.
And when you have positions like these, you’ll see a lot less volatility in your portfolio. Here’s the three-month annualized volatility for this portfolio of three stocks alone versus also purchasing and rolling up put options.

There’s a lot to like about this chart, considering the volatility of these three specific stocks.
Well, this hypothetical scenario ends in January. For RIMM and Netflix, all I would need to do is sell the puts and the stock and be done with it. For Apple, I’d have to make some tough decisions about whether to roll out those 410 puts, roll them down to take some money out of the position, or simply let them expire.
As I mentioned above, I don’t consider using LEAPS put options as the best way to hedge stock risk. I was using those options to illustrate an overall concept – that you can be long a stock and ladder up the puts in a way that reduces overall volatility And I wanted to show what happens in various scenarios: Stock does well (AAPL). Stock does well until it sucks (NFLX). And stock never does well right before your eyes (RIMM).
Sometimes, as in the case, of Netflix and RIMM, you end up owning some really deep-in-the-money puts. I happen to own some (although not in these three stocks) and use the opportunity to sell other put options against them. I’ll explain my strategy for doing that in a future article.

Disclosure: I am long AAPL.