One of the challenges investors and traders face is the balance between risk vs. reward. With so many hedging tools and products available, investors can often leave with more questions than answers. However, it’s better to stick to the basics like protective puts, versus choosing ETNs designed for the sophisticated investor.
For example, many investors were caught by surprise when the Velocity Shares Daily Inverse VIX Short-Term ETN imploded in February 2018. In one single day, shares of the ETN collapsed by more than 90%, leaving investors holding the bag.
That said, Credit Suisse, the maker of XIV, warned investors well ahead of time. All they had to do was read page 197 of the prospectus:
The long term expected value of your ETN is zero. If you hold your ETNs as a long-term investment, it is likely you will lose all or substantial portion of your investment.
Even before the XIV implosion, I warned readers in this post not to hold these volatility products for an extended period because of their danger.
That said, if volatility ETNs are just good for trading and not long-term investments, what else should investors and traders look at?
Before we get into the strategy, let’s first define what it is. A protective put is a long put option which is purchased against a long stock position.
Mechanics Behind the Protective Put
There is a cost associated with terms like coverage and protection. When you buy a protective put, the goal is not to make money but to save it. Furthermore, a protective put will cut into your profit potential. It works the same way insurance does; you pay for certain levels of coverage. And like insurance, you select how much coverage you need.
(a protective put is a combination of a long stock position and a long put option)
There are three types of put options, in-the-money, at-the-money, and out-the-money.
Let’s take a look at some different types of ways you can use the stratetgy.
Protective Put: OTM Options
The cheapest form of insurance you can get is buying out-the-money options. However, you get what you pay for.
Let’s take a look at an example.
Apple started the second quarter of 2019, trading near $190 per share.
Take a look at these put options expiring in over a year:
Let’s assume the investor is long 1,000 shares at $190 and they want to be hedged against a steep move down.
The $165 puts are trading for $9.05. That said the trader would need to buy ten contracts to cover their 1000 shares.
The total cost for the ten contracts is $9,050. The traders stock position has a value of $190,000. Relative to its stock position, this hedge is about 5% of the value of the portfolio.
How It Works:
Scenario: Stock crashes and drops by 40% or more. A 40% drop would take the stock down to $114. If the trader is long only, they would be down $76,000 in the position. However, if they are hedged with the $165 puts, they lose about $34,000. That said, the $165 puts hedge you for anything past a 20% decline.
As you can see, when stocks are trending higher, hedging looks like a bad expense. However, during periods of uncertainty, and market sell-offs, the hedged trader takes the least amount of damage.
Protective aka Married Put: ATM Options
For example, let’s assume an investor wants more protection, and instead of buying OTM put options, they want something closer to at-the-money.
Well, the $190 AAPL puts are trading at $18.90 per contract. That said, if the trader were to be fully hedged, like in the previous example, it would cost them $18,900.
What level of coverage does that give them for +1 year?
To figure this out, you need to know how to calculate the break-even for this strategy. In this case you take the strike price, 190, and subtract that by the premium ($18.90).
The break-even point is $171.10. Which means that the position is fully hedged after a move below $171.71.
Married Put: ITM Options
Still using the Apple example from above, let’s assume the trader is in need of more protection, so they buy the AAPL $195 puts for $21.25. That said, in order to hedge 1000 shares, the trader must buy ten contracts which will cost them $21,250.
How much coverage do the $195 puts offer?
Well, the break-even on this trade is $173.75. Which means that the position is fully hedged after a move below $173.75.
Are Protective Puts Just For Investors?
If you look at the risk profile of a protective put, it seems the same as a long call option. In other words, your downside is hedged while the upside is undefined.
When is it a good time to buy protective puts?
Options tend to cheapen after a catalyst event. In other words, after a catalyst, implied volatility in options declines, making options relatively cheap.
Furthermore, if you wait for the catalyst event, then you’ll be paying more in option premium. For example, ahead of an earnings release, option premiums are juiced and expensive to buy.
However, the best solution is to look to hedge with the nearest-term options.
Think of a protective put as a limited-risk strategy. However, I wouldn’t consider it a defensive strategy because it has the same upside as a long call option has.
Pros and Cons of the Married Put
Pros: A risk-defined strategy that gives traders plenty of upside potential. Levels of protection vary depending on which strike price you select.
Cons: There is a cost associated with hedging. That said, a married put is more conservative than a long stock position, but it also has greater safety features.
The protective put gives traders and investors a chance to participate in a stock or ETFs upside while limiting downside risk. This strategy makes sense for investors or traders who want to limit their risk. It can be a beneficial strategy if you’re trading around volatile events like an FDA announcement, or an earnings release. Despite the protection the strategy offers, it’s still an offensive and bullish strategy.
Furthermore, if you’d like to learn more about options and hedging, then make sure to get a copy of Option Profit Accelerator.