Option Risks and Rewards, part 3

Russ Allen

In the last two articles I discussed using put options as a risk management strategy in your options trading plan. First from the point of view of an investor who might buy puts to protect a stock investment; and then from the point of view of the person who sells those puts to the investor.

I noted that from both perspectives the put option is like an insurance policy. The put buyer is paying to insure himself against a drop in the value of his/her stock. This is another way of saying that owning the put reduces or removes the investor’s market risk, but market risk can’t be made to vanish entirely. When the value of a stock goes down someone has to lose. The person who sells the put option to the stock investor has volunteered to be that loser if necessary (if in fact the stock price does go down). This is very much like the fire insurance company that will take the loss if your house should burn down.

As individual investors, we can choose to be on either side of this insurance contract. Let’s say that we decide that we would like to act like an insurance company, taking in premiums for insuring stocks that we think will not go down in value. We can sell puts. Every time we sell a put, we get paid a fixed amount of money up front – the price of the put option, referred to appropriately as the put premium. After selling the put, we then wait out the term of the option to see if the price of the stock drops. If not, the put premium we received is clear profit. During the time before the put expires we are said to be short the put since we sold it without first owning it.

We know that occasionally the price of the stock that we insured will drop; just like the insurance company knows that some of the houses they insure will burn down. How is the insurer protected from being ruined by the market risk they have assumed?

Free Trading WorkshopFor example, every few years a bad fire season occurs and many of the multimillion dollar homes in the canyons near Malibu, California burn down. If an insurer only sold insurance on homes in Malibu they could count on being ruined in short order. Their risk would be far too concentrated. Instead, a giant insurance company protects itself by insuring many thousands, or millions, of homes in different locations. The probability that a large percentage of those widely separated homes will burn down in a given year is minuscule. The insurer is spreading its risks geographically.

It would be nice to be able to follow a similar philosophy, selling puts on many different stocks in widely separated “neighborhoods” (market sectors). There are also puts based on exchange-traded funds that represent things that are not even stocks – things like bonds, gold or real estate. Selling puts on a variety of these ETFs is like selling insurance on houses that are not only in different neighborhoods, but in different countries.

Sounds good. But if we don’t have millions of dollars to spread around like that, can we sell insurance on only one or a few things at a time and still protect ourselves from ruin if a disaster happens to all of our insured properties?

Yes we can, by buying some insurance of our own. This is another tactic that insurance companies use, by the way. Say that an insurance company was to discover that its new agent in Malibu was a prodigy, and suddenly, in fact, they did find themselves insuring all the homes in Malibu. Even if they had many other properties in other locations their risk could now be way too concentrated for comfort. Their answer is to buy insurance wholesale to back them up.

We can similarly lay off part of the market risk represented by a short put by buying a put at a lower strike price. We then limit our own risk on that particular trade.

As mentioned in the last article, on July 3, the S&P 500 index stood near 2070.  There was a demand zone at a major low about 100 points away, at 1972. We could have sold puts at the 1970 strike price, expiring in August, for $20.65. These options have a multiplier of 100. This means that we are insuring a value of 1970 X 100, or $197,000; and we are receiving a premium of $20.65 X 100, or $2065.  We would be tying up $197,000 for the duration of the trade.

If the S&P remained above the 1970 level until the puts’ expiration on August 21, then the $2065 would be clear profit. That amount along with our $197,000 original investment would then be available for the next trade.

But what if it didn’t stay above 1970? What if the S&P dropped a long way, say to the next previous low at 1820? In that case, we would be liable for the difference between the 1970 strike and the 1820 value, or 150 points, times 100. This would be $15,000, far more than the $2,065 that we had received.  Our net loss would then be $15,000 less the original $2065 premium received, for a net of $12,935.

If we did not care for this possibility, we could have bought our own insurance in the form of put options at a lower strike. A put at the 1950 strike would have cost us $1710. Subtracting this from our $2065 credit from selling the 1970 puts would leave us a net credit of only $355.

But our worst-case loss was now also much smaller. If that drop to 1820 happened, we would still have to pay $15,000 to the owner of the 1970 put we had sold, BUT we would in turn receive a payout on our 1950 put. This payout would be equal to the difference between that 1950 strike and the 1820 index value, or 130 times the multiplier of 100; a total of $13,000 cash to us. The net result would now be just $15,000 cash out vs $13,000 cash in, or a net of $2,000 out. Taking into account our original $355 net credit, our maximum loss would be just $1645.

Because we could lose at most $1,645 on this trade, our broker would not require us to tie up any more money than that. Instead of $197,000, we would need only $1645 in margin to initiate the trade.

So, we were still an insurance company taking in a net of $355 in premiums, but we were now backed up by another insurance company (the seller of our own long 1950 puts) .That worst-case scenario was now a very survivable loss ($1645) instead of a major catastrophe ($15,000 – or maybe even more if the index went even lower than 1820).

Best of all, our probability of making money on this trade was very large. The probability of the index being below 1970 at expiration was quite low, just about 10%. Therefore, we had a 90% chance that the index would NOT b33e below 1970. Any value above 1970 would result in our making our maximum profit since the 1970 puts we sold were worthless, not requiring any action to liquidate.

So to boil down the possibilities:

  • Index stays flat, or goes up, or drops but remains above 1970, we keep $355 premium on a $1645 investment.
  • Index drops to $1950 or lower, we pay out $1645 as a net loss.
  • Index drops to somewhere between 1970 and 1950, our $355 profit is reduced by $100 for every one-point drop below 1970, with a worst-case result of a $1645 loss at 1950 or lower.

So, by buying the 1950 put as insurance against the insurance policy that we ourselves sold, we transfer most of the market risk we took on to another third party. We end up with an amount of market risk we can live with and a potential profit large enough to compensate us for that risk.

This is an example of the many possibilities provided by options. An educated trader can pick and choose the kind and degree of risk they wish to take and fine-tune it to a high degree. Educate yourself and stay on the right side of those trades.

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This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.