Put Options as Insurance

With the stock market at all time highs it is prudent to look at strategies that can help protect any investments from a market dip, this is especially relevant with any investments made with leverage such as Margin Lending (share gearing).

There are a number of reasons why an investor may decide not to simply use a stop loss with investments. The most common reason being that selling the stock may cause a capital gain (undesireable from a taxation perspective) or cause the investor to miss out on a dividend or franking credit.

Protecting your position is referred to as hedging.

What the investor is really doing when they hedge is insuring themselves against making the wrong future investment decision. The investor may either inadvertently sell the stock just prior to it rising in value or alternatively, they may simply hold onto the stock as it falls in value. If you protect your position with a hedge, you can be right either way.

By using either CFDs (contracts for difference) or Options (Exchange traded options) the investor can hedge their positions with the minimum of effort.

Hedging with CFDs merely involves 'shorting' the position with the exact number of underlying shares the investor holds with CFDs. For example if you have 5,000 BHP shares you would short 5,000 BHP CFDs. The costs would be the brokerage of the CFD and the interest component.

The most widely understood example of using options as insurance to protect a stock is when an investor purchases a put contract . The concept is that the increase in value of the put contract will compensate for some of the monetary loss if the stock value falls.

Moreover, it is possible to structure your Puts in a way that reflects your market expectations and your analysis of the risk.

Example

Using BHP on the 25th September 2007; when it was trading around $44.00 per share, the October at-the-money $44.00 strike had an asking price of $1.48; the October out-of-the-money $43.00 was asking $1.11 and the October in-the-money $45.00 put was trading at $2.00.

In-the-Money Put. With an in-the-money put you suffer the lowest overall loss if the stock drops sharply, but you also have the lowest gain if the stock rises. This is because it protects the downside more than the other puts, hence you would say that it offers the maximum insurance.

But does it? After all, if you just wanted to protect against a loss, your best choice would be to sell the stock and hold cash. But then, of course, you would have given up the chance for any further gains in the stock.

At-the-money Put. Buying the at-the-money $44.00 strike put at $1.48 is the maximum insurance. Why? Because if you are uncertain about the direction of the stock, and do not want to be wrong if the stock makes a big move in either direction, then the at-the-money strike put is the insurance you want to buy.

With the at-the-money put, if the stock rises $2.00 by the October expiration, to $46.00, with 1000 shares the investor will have participated in all of the $2,000 gain, but will be out of pocket for the $1480.00 paid to purchase the put (your accountant would be able to advise you regarding this amount being tax deductible). Alternatively, if the stock falls $3.00 to $41.00, the investor can choose to exercise to the $44.00 Put option to sell his/her shares at $44.00 or sell the put option back into the market at a value of around $3.00, giving rise to a gain of $3.00 - $1.48 = $1.52 less the drop in value of the shares. In either scenario all he or she will be out of pocket is the time value component on the option.

Out-of-the-Money; If you are more bullish then you may decide on the $43.00 out-of-the-money put. Your maximum loss (with 1000 shares) is $1,000.00 ( the gain of $1.00 ($1,000) - The the cost of the put ($2,000)), However, if the stock rises instead of declines, your gains will be a lot better than if you hedged by buying the at-the-money put.

With an in-the-money put you are moving towards selling off your stock, but insuring yourself against the wrong decision by retaining the right to some upside potential if the stock makes a large upward move.