For Protection: Sell calls or Buy puts?

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Mark,

I
know this could be a rookie comment but it hit me today that I could buy
short-term portfolio "insurance" in the form of selling a deep in the money call
for the upcoming month. Something with a high Delta that will hedge a big
move down.

I thought about buying a Put as I read most investors seem to
favor, but I would rather reduce my basis with the Call premium than
raise my basis with the Put.

It will take some monitoring to limit the
loss in the Call if the market moves back up but it seems like a good
alternative to buying a Put. (I would have to monitor the loss with the Put as
well.)

Thanks

Larry

***

Good question.  I must make assumptions due to ambiguity.

1) When you speak of selling a Call or buying a Put, the strike prices are crucial.  I assume that are using options with the same strike
price and expiration date.

2) Yes, when trading options, you can sell a deep in the money (ITM) call option to get short 80 to 100 deltas.  Yes, this provides decent downside protection.  Its effectiveness depends on position size.

  • If you own 1,000 shares of stock, one call will not help much
  • If you own 200 shares, it cuts downside risk considerable, but hurts the upside
  • If you own only 100 shares, then you have very little profit potential on a rally

This strategy is not traditional 'insurance.'  It's more of a hedge, or risk-reducing play.  So if that's the plan – selling some delta because you have too much downside risk, then this is okay.  But it would be easier to unload a portion of your position and forget insurance.

3) It's true that buying puts is expensive, and is often a huge deterrent to investors who want to own insurance.  Thus, it's a real trade-off.  Pay for the puts and own real insurance – insurance that guarantees a minimum value for your position – or look for ways to save money and own less effective protection.

If you choose to buy that far OTM put (corresponding to the strike price of the call you are considering selling), the put will not be costly.  However, it takes a significant decline before insurance kicks in.  It's equivalent to owning an insurance policy with a large deductible.

I understand the difficulty in making a decision.  We all want to reduce, rather than increase, the cost basis of our holdings.  I tend to own insurance when it is inexpensive (IV is far too high for that right now).  The way I provide minor insurance for my portfolio is to reduce position size.  It's one way to get some protection without having to pay for those costly puts.

One more idea:  Instead of owning 'complete' protection, you can buy put spreads.  These provide limited protection at a much lower cost.

775


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8 Responses to For Protection: Sell calls or Buy puts?

  1. semuren 08/31/2010 at 7:57 AM #

    Mark:
    Maybe you can address the idea of owning “unit” puts that your fellow Expiring Monthly contributing editor Mark Sebastian advocates. It seems that his idea relates to the question here.

  2. Mark Wolfinger 08/31/2010 at 8:26 AM #

    Sem,
    I prefer to own fewer ‘extra options’ than a bunch of far OTM.
    This is worthy of a post. Thanks

  3. Robert 08/31/2010 at 2:58 PM #

    Mr. Wolfinger,
    I was under the impression (after reading about calls) that a put gave the buyer the right to sell their shares (if they owned them) in a stock at the strike price on the expiration date as long as it was above the current stock price. From what I am reading I seem to be wrong. I own INTC and it has been going down. If I believe for the next two months their might be continued downward pressure on it but didn’t want to sell the stock. If I buy an October, deep in the money put, say $25 strike (stock price is $18), and the option cost is only $5.00, how would this work if the stock stayed at the current price? Thanks,

  4. Joe 08/31/2010 at 6:31 PM #

    Mark,
    As way of reducing risk from a downward move could you recommend the most appropriate hedge for a portfolio of condors on an index? I have considered otm puts, debit spreads, VIX calls & other calls on other VIX products, even Gold & bond ETFs.

  5. Mark Wolfinger 08/31/2010 at 8:25 PM #

    Robert,
    1) Your impression is correct.
    A put does give its owner the right to sell shares at the strike price, on expiration [or ANY EARLIER TIME].
    I don’t know what you are reading that would make you believe that the above is wrong.
    2) A deep in the money put, such as the Oct 25, does not trade as less that it’s intrinsic value. This option is in the money by seven points, and you cannot buy it for less than $7 [not $5].
    3) If the stock stayed at the current price, your put would be worth $7 when expiration arrives. That’s because its owner can sell stock at $25 and buy it at $18. The difference is $7.
    Buying this put now would protect you from losing any more money – if the stock continues to decline. If the stock drops by another point, you will earn that point on the put.
    There is no profit potential here for you. If the stock drops further you earn nothing. If it rallies you earn nothing (unless it gets to $25 before expiration in October).
    I’m not sure what you are trying to accomplish, but buying the Oct 25 put is not going to be much help.
    4) If you believe the stock is not moving lower, do not buy a put.
    5) If you believe the stock is moving lower, why don’t you want to sell your shares? You can always replace those shares with a call option – just in case the stock rallies. But, if you are bearish, why own a long position?
    If you require clarification, please let me know just what it is you want to know.
    Regards

  6. Mark Wolfinger 08/31/2010 at 8:43 PM #

    Joe,
    There is no ‘most’ appropriate. I’ll offer a more complete on Sept 2.
    Thanks for the question.

  7. semuren 09/01/2010 at 6:16 AM #

    look forward to the post of maybe a point counterpoint in expiring monthly

  8. Mark Wolfinger 09/01/2010 at 9:36 AM #

    Sem,
    Have not given this a lot of thought yet. Now forced to do so. Yes, could be a good Wolf Against the World mini-debate. Thanks