Options strategy to protect downside

Don't Forget Your Protective Collar.

When the markets start swinging wildly, investors scurry for safety. They might head for indexed annuities, principal protection funds or other investments that offer some type of downside defense, but even though these investments have many applications, they might not be suitable, because they frequently require a long-term commitment.

A protective collar is a strategy that could provide short-term downside protection. It offers a way to protect against losses, allows you to make money when the market goes up and sometimes is accomplished at little or no cost.

Protect Against Loss.

For example, suppose you own 100 shares of Digit Computer that currently trades at $110 per share. Because you bought the stock at $25 per share, you have an $8,500 gain ($11,000 - $2,500).

A Digit Computer put option with a strike price of $100 that lasts 12 months would lock in a $7,500 profit ($10,000 - $2,500), regardless of how much the shares fell during that time. So far, so good. You've set a floor on how low your stock can go, but, this insurance comes with a price.

Now, let's assume you have a 12-month put option, with a strike price of $100, which cost $11 per option. This means your outlay will be $1,100 ($11 x 100 shares). Because an out-of-the-money put option typically is purchased, you will have to figure out how to come up with the $1,100 to pay for your put contract.

Assume that a 12-month call contract with a strike price of $140 sells for $12 a share. This will get you $1,200 ($12 x 100 shares). In this case, you actually netted $100 ($1,200 - $1,100) on the two transactions.

In this example, the protective collar gave you a maximum downside risk of 10% ($100 put option strike price / $110 current market value) and an upside potential of 27% ($140 call option strike price / $110 current market value).

Stock Goes Down.

Overall, you would have earned a small net profit from the sale of the call and the purchase of the put (+$100). This would make your total profit $7,600.

You'll miss out on the profit above $140, but you'll still get to keep the additional $3,000 in gains ($140 - $110 = $30 x 100 shares) in addition to the original $8,500 and the $100 from the net option transaction for a total profit of $11,600.

Stock Doesn't Move.

Your put contract is worthless because the stock didn't get to the $100 strike price and your call contract's buyer won't buy your stock for $140 because they can get it on the open market for $110. Therefore, the call expires without being exercised, and you keep your stock and your $100 from the options transaction.

For example, what if you own a stock that has risen significantly since you bought it? Maybe you think it has more upside potential, but you're concerned about the rest of the market pulling it down.

One choice is to sell the stock and buy it back when the market stabilizes. You might even be able to get it for less than its current market value and pocket a few additional bucks. The problem is, if you sell, you'll have to pay capital gains tax on your profit.

By using the collar strategy, you'll be able to hedge against a market downturn without triggering a taxable event. Of course, if you're forced to sell your stock to the call holder or you decide to sell to the put holder, you'll have taxes to pay on the profit.

You could possibly help your beneficiaries, too. As long as you don't sell your stock, they'll be able to take advantage of the step-up in basis when they inherit the stock from you.

The Bottom Line.

You could use the stock as collateral for a loan. Depending on the liquidity and strength of the stock, your banker might loan you 5-70% of its market value. If you set up a protective collar on your stock, it's possible that the lender will loan you more.

Then you could take the cash and reduce your risk by investing in other securities without selling your stock.

Note : The hypothetical example shown above does not include the cost of commissions on the stock or options trades, which could take a chunk of your profit.

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If you have unrealized capital gains, you are probably a happy trader. But the potential for volatility and a market decline can be a concern for any investor with unrealized profits on long positions. Enter the protective put, a strategy that is designed to limit your exposure to risk.

What is a protective put?

There are two types of options: calls and puts. The buyer of a call has the right to buy a stock at a set price until the option contract expires. The buyer of a put has the right to sell a stock at a set price until the contract expires.

If you own an underlying stock or other security, a protective put position involves purchasing put options, on a share-for-share basis, on the same stock (watch video to the right). This is in contrast to a covered call which involves selling a call on a stock you own. Options traders who are more comfortable with call options can think of purchasing a put to protect a long stock position much like a synthetic long call.

The primary benefit of a protective put strategy is it protects against losses during a price decline in the underlying asset, while still allowing for capital appreciation if the stock increases in value. Of course, there is a cost to any protection: in the case of a protective put, it is the price of the option. Essentially, if the stock goes up, you have unlimited profit potential (less the cost of the put options), and if the stock goes down, the put goes up in value to offset losses on the stock.

A hypothetical trade.

The protective put acts like insurance if a stock declines.

Profit/loss diagram of the protective put strategy.

Let’s highlight how the protective put works. 1 Assume you purchased 100 shares of XYZ Company at $50 per share six months ago. The cost of this trade was $5,000 ($50 share price multiplied by 100 shares).

The stock is now trading at $65 per share, and you think it might go to $70. However, you are concerned about the global economy and how any broad market weakness might impact the stock.

A protective put allows you to maintain ownership of the stock so that it can potentially reach your $70 price target, while protecting you in case the market weakens and the stock price decreases as a result.

When the stock is trading at $65, suppose you decide to purchase the 62 XYZ Company October put option contract (i. e. the underlying asset is XYZ Company stock, the exercise price is $62, and the expiration month is October) at $3 per contract (this is the option price, also known as the premium) for a total cost of $300 ($3 per contract multiplied by 100 shares that the option contract controls).

If XYZ continues to go up in value, your underlying stock position increases commensurately and the put option is out of the money (meaning it is declining in value as the stock rises). For instance, if at the expiration of the put contract the stock reaches your $70 price target, you might then choose to sell the stock for a pretax profit of $1,700 ($2,000 profit on the underlying stock less the $300 cost of the option) and the option would expire worthless.

Alternatively, if your fears about the economy were realized and the stock was adversely impacted as a result, your capital gains would be protected against a decline by the put. Here’s how.

Assume the stock declined from $65 to $55 just prior to expiration of the option. Without the protective put, if you sold the stock at $55, your pretax profit would be just $500 ($5,500 less $5,000). If you purchased the 62 XYZ October put, and then sold the stock by exercising the option, your pretax profit would be $900. You would sell the stock at the exercise price of $62. Thus, the profit with the purchased put is $900, which is equal to the $500 profit on the underlying stock, plus the $700 in-the-money put profit, less the $300 cost of the option. That compares with a profit of $500 without it.

As you can see in this example, although the profits are reduced when the stock goes up in value, the protective put limits the risk to the unrealized gains during a decline.

When might you execute a protective put strategy?

Protective puts can be a particularly useful tool for traders and investors who expect a short - or intermediate-term decline in the price of a stock they own and do not want to sell. You might be asking: Why would anyone want to not sell a stock that they expect might go down? Well, there can be several reasons why, even if you anticipate a possible decline, you might not want to sell a stock. For example:

You are concerned that you will sell too early and buy back too soon. The stock is in a company you work for and you are restricted from selling, or you would simply prefer not to sell. Potential tax implications may be disadvantageous. 2 Trading costs associated with selling and then subsequently rebuying shares after you expect the decline to be over could significantly eat into your profits.

One or a combination of these reasons might make it beneficial to consider a protective put. Also, a protective put can help investors limit the potential risk of a stock ownership position before an earnings report that could result in a volatile move. Traders should recognize that the cost of options tends to be relatively higher before an increase in expected volatility, and so the premium for a protective put might be more expensive before an earnings report.

Learn more.

Learn more about the protective put strategy and trading options. Find options contracts. To test single - and multi-leg options strategies try a strategy evaluator (login required).

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Downside Protection.

DEFINITION of 'Downside Protection'

The use of an option or other hedging instrument in order to limit or reduce losses in the case of a decline in the value of the underlying security. Downside protection often involves the purchase of an option to hedge a long position. Other methods of downside protection include using stop losses or purchasing assets that are negatively correlated to the asset you are trying to hedge.

BREAKING DOWN 'Downside Protection'

An example of downside protection would be the purchase of a put option for a particular stock. If an investor already owns shares and the price of that stock falls, the value of the option will increase and thus limit the total loss exposure.

Protective Put (Married Put)

Description.

A long put option added to long stock insures the stock's value. The choice of strike prices determines where the downside protection 'kicks in’. If the stock stays strong, the investor still gets the benefit of upside gains. (In fact, if the short-term forecast brightens before the put expires, it could be sold back to recoup some of its cost.) However, if the stock falls below the strike, as originally feared, the investor has the benefit of several choices.

One option is to exercise the put, which triggers the sale of the stock. The strike price sets the minimum exit price. If the long-term outlook has turned bearish, this could be the most prudent move.

If the worst seems to be over, an alternative for still-bullish investors is to keep the stock and sell the put. The sale should recoup some of the original premium paid, and may even result in a profit. If so, it in effect lowers the stock's cost basis.

Net Position (at expiration)

MAXIMUM GAIN.

MAXIMUM LOSS.

Stock purchase price - strike price - premium paid.

If the investor remains nervous, the put could be held into expiration to extend the protection for as long as possible. Then it either expires worthless or, if it is sufficiently in-the-money, is exercised and the stock would be sold.

The put can provide excellent protection against a downturn during the term of the option. The major drawback of the strategy is its cost, which raises the bar on netting upside profits. Investors who aren't very bullish might have better strategy alternatives.

This investor is bullish overall, but worries about a sharp temporary decline in the underlying stock's price.

If the investor is worried about the longer-term prospects also, other strategy choices might be a covered call or liquidating the stock and selecting another.

This strategy consists of adding a long put position to a long stock position. The protective put establishes a 'floor' price under which investor's stock value cannot fall.

If the stock keeps rising, the investor benefits from the upside gains. Yet no matter how low the stock might fall, the investor can exercise the put to liquidate the stock at the strike price.

Motivation.

This strategy is a hedge against a temporary dip in the stock's value. The protective put buyer retains the upside potential of the stock, while limiting the downside risk.

Some examples of when investors consider protective puts:

Before an imminent news announcement that could send a favorite stock into a slump.

Variations.

The married put and protective put strategies are identical, except for the time when the stock is acquired. The protective put involves buying a put to hedge a stock already in the portfolio. If the put is bought at the same time as the stock, the strategy is called a married put. Synthetic call is simply a generic term for this combination.

The maximum loss is limited. The worst that can happen is for the stock to drop below the strike price. It does not matter how far below; the put caps the loss at that point. The strike becomes the 'floor' exit price at which the investor can liquidate the stock, regardless of how low the market price might fall.

The amount of the total loss depends on the cost at which the stock was acquired. If the purchase price of the stock was the same as the strike price of the option, then the loss is limited to the premium paid for the put option. If the stock's purchase price was higher (lower), then the loss would be greater (smaller) by exactly that amount.

In theory, the potential gains on this strategy are unlimited. The best that can happen is for the stock price to rise to infinity.

If the stock rises sharply, it does not matter that the put expires worthless. A protective put is analogous to homeowner's insurance. The asset is the primary concern, and to file a claim means there has been a loss in the asset's value. A homeowner would prefer that the insured home remain intact, even though it means the insurance premiums are forfeited. Likewise, a protected put holder would rather see the stock do well than have to resort to the put's protection.

Profit/Loss.

This strategy retains the stock's unlimited upside while capping potential losses for the life of the put option.

The profitability of the strategy should be viewed from the standpoint of a stockowner; rather than in terms of whether the put option turns a profit. The put is like insurance; it gives peace of mind, but it's preferable not to have to use it at all.

Consider a protective put versus a plain long stock position. The protective put buyer pays a premium, which lowers the net profit on the upside, compared to the unhedged stockowner. Returns will lag by the amount of the premium, no matter how high the stock might climb. But in return for the cost of the hedge, the put owner can precisely limit the downside exposure, whereas the regular stockowner risks the entire cost of the stock.

If the investor is reluctant to pay the cost of a put hedge yet can no longer accept the possibility of large losses on the stock, a different strategy might be called for.

There is no single formula to determine the strategy's breakeven point. Whether this strategy results in a profit or loss is largely determined by the purchase price of the stock, which may have occurred well in the past at a much lower price.

Assume the stock was acquired at or just below its current price. If the unrealized stock gain is less than the amount of the premium, the strategy would break even at expiration at the original stock purchase price plus the put premium.

Breakeven = starting stock price + premium.

Volatility.

An increase in implied volatility would have a neutral to slightly positive impact on this strategy, all other things being equal. On one hand, the investor might perceive a greater value to having the put protection, since the market seems to think a big move has become likely.

But even if the investor disagrees with the market and has become less worried about the downside, an increase in implied volatility could help. If the optimistic put holder decides to terminate the hedge to recoup some of its cost, greater implied volatility would tend to boost the put option's resale value.

Time Decay.

The passage of time will have a negative impact on this strategy, all other things being equal. The protection of the hedge ends at expiration. As for the put's resale value in the market, the option tends to move toward its intrinsic value as the term draws to an end. For at-the-money and out-of-money puts, intrinsic value is zero.

Assignment Risk.

Expiration Risk.

None, providing that the investor knows the pre-established minimum value for automatic exercise. If the protective put holder carries the open position into expiration, it indicates a desire to exercise the option if it's sufficiently in-the-money. Investors with no intention of exiting their stock position may need to sell to close the their put prior to expiration if it is in-the-money.

A note to investors who are considering protective puts because they cannot liquidate the stock right away but are nervous about its prospects: it's important to make sure that a put hedge is the right solution from all standpoints, including law and taxes. For example, if employment-related stock sale restrictions apply, a protective put might be considered just as unacceptable as selling the stock outright. Also, depending on a number of factors, the IRS might treat a particular protective put as equivalent to liquidating the stock, triggering unwanted tax consequences. Just another reminder to get all the facts first.

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