Lessons from the Pros

Options

Puts for Protection – Update

I’ve done a series articles in which I described the use of put options as a protection against losses on holdings of stocks or exchange-traded funds.

Today, we’ll do one last update on this theme to show that the option trading strategy worked as planned.

In the original article I used the example of a 100-share position in SPY, the exchange-traded fund that tracks the S&P 500. At that writing on September 11, 2018, SPY was at $289.33 per share. The put that we looked at as protection was one at the $265 strike that was due to expire six months later, in March 2019. In September that put was priced at $4.91 per share. The 265 strike was chosen so that an arbitrary 10% loss was the worst case scenario if SPY went down.

In the update in January 2019, we noted that by December 24, 2018 SPY had indeed melted down from $289 to $234, a drop of $65 per share or almost 19%, the worst fourth quarter for the stock market since the Great Depression.

This was a great stress test for our $265 protective puts. We showed that the puts that we had selected three months earlier to limit our loss to no more than 10% of that $289 original price, had done exactly that. Rather than the full 19% that SPY had dropped, our loss to that point would have been exactly 10%, if we had liquidated. That was all we could possibly lose no matter how much further SPY dropped, even to zero. Our put options were now earning a full dollar per share for every additional dollar that SPY dropped, completely canceling out any further losses, no matter what.

At this point in December 2018, the March 2019 put options that we held still had three months until they expired. There was no need to liquidate the SPY position before March, since the loss could not possibly increase so we were free to hold it and the puts until March. It was possible that SPY might recover somewhat, and our loss might even be less than the 10% worst-case result we now had.

Fast-forward to the expiration date of the puts – March 15, 2019. After a huge rally in January, February and March, SPY had climbed from $234 back up to $281, just $8 or 1.7% below our $289 starting price. We still owned the SPY shares and could still participate in any further upside moves. If we wanted to, we could buy more insurance to replace the expired policy.

Here’s what the SPY chart looked like at that time:

Option chart showing the results of a trade using puts to protect from losses.

In the end, spending the $5 or so per share for the insurance had allowed us to weather a hair-raising $65 / 19% drop without flinching and hang in until the SPY had almost completely recovered. This resulted in an end result of just about a 4% haircut, including the cost of the insurance – and, we still own the SPY.

In this five-part series, we’ve pretty thoroughly covered how put options work from the point of view of the put buyer, who is purchasing insurance. In the future, we’ll look at it from the point of view of the put seller, who acts like an insurance company. As we’ll see, selling insurance is a pretty profitable business too.

Options truly do give you options – ask your local OTA center about learning more.


DISCLAIMER 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.