In an earlier article we discussed an option strategy referred to as the Covered Call. This can be a profitable strategy for any investor when done properly. It enhances the profit from holding a stock or exchange-traded fund position.
There are other ways a long-term investor can benefit from the use of options. Today we’ll look at another one of them.
This strategy is the protective put option. It can be used to protect an existing position from incurring a large loss in case the market plummets.
You may know that a Put option functions very much like an insurance policy. You pay a certain premium for a Put option on a stock or exchange-traded fund. In exchange for that cash payment, you receive the right to sell that stock at a fixed price (called the strike price). With the put in place, your stock position is now insured at the strike price. If the stock drops below that, even if it drops to zero value, you are guaranteed that you can sell the stock at the strike price.
Here is an example:
The exchange-traded fund QQQ at this moment is near all-time highs, around $180 per share. Just six months ago, it was under $150. Let’s say that an investor is willing to absorb the loss if QQQ drops no lower than $150 (a 16.7% drop), but no more than that. There are Put options available that expire in six months at the $150 strike. Their cost today is $1.90 per share, or $190 per option contract. Each contract protects 100 shares of QQQ stock. Today those 100 shares would be worth a total of $18,000.
If the investor pays the $190 today for the contract, he or she has the absolute right to sell those QQQ shares for $150 per share ($15,000 for the 100 shares) at any time up to the expiration of the puts on January 18, 2019. The worst possible case now is that QQQ does in fact drop below $150 and stay there until January. In that case the investor would exercise the option, receiving $15,000 for the stock. This would be a loss of $3,000 on the stock, plus the $190 paid for the put – but that’s the worst it could be. A loss of $3,190 doesn’t sound like much fun. But without the put, it could be so much less fun.
Although QQQ has been a star performer in the current bull market, we should not forget that in the crash of 2008 QQQ dropped by 54%, in the crash of 2000 it dropped by 83%, and in 2015 it dropped 25% in one week. So, it is certainly capable of some breathtaking drops, and 16.7% is well within the realm of probability.
If an investor is even more risk-averse, it is possible to buy a lower-deductible policy at a higher price. If we were willing to absorb a drop of only 10%, to $162, we could arrange that too. The six-month puts on QQQ at the 162 strike are $3.40 per share ($340 for a contract). These guarantee a loss of no more than 10% of the value of the position, plus the $340 cost.
Whether you consider put options worth the cost is up to you. Whatever your approach to investing, it should be a systematic one. One benefit of insuring with puts is that it immunizes you against panic, allowing you calmly to follow your investment plan. For that reason alone, put options as insurance can be beneficial.