Protection: Buy puts or sell calls

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I received a very basic question from a reader and decided this is an excellent topic for the options rookie. It may eliminate confusion concerning the difference between puts and calls.

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Hi Mark

I own 1,000 shares of AAPL. Do I use puts or calls to protect my position?

Thanks,

Ruth

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Hello Ruth,

The answer is ‘either.’

The protection provided by selling calls is vastly different from that of buying puts. Let’s see if I can help you understand the difference so that you can make an intelligent choice.

My preference is to sell calls – one call for each 100 shares of stock owned. However, it’s a personal preference and not necessarily the better choice for you. Let’s consider your alternatives

Buying puts

If you want good protection – if you want to be certain you don’t get clobbered if the stock takes a big tumble – if you are afraid that such a tumble is possible, then you would probably want to buy puts. I say ‘probably’ because buying puts is often an expensive proposition. In today’s less volatile environment, there’s a good chance that you would be perfectly happy to pay the necessary cost.

You may buy a variety of put options, and as with any insurance, the greater your protection, the higher the cost of that insurance.

As I write, AAPL closed for the day near $350 per share. If you want to buy Apr 340 puts (expiring in 65 days), the cost is approximately $1,000 per put. You need 10 puts to protect 1,000 shares. That’s $10,000.

Paying that sum to protect an investment worth $350,000 seems to be a reasonable cost. If AAPL is lower than $340 per share when the options expire in April, you may exercise your right to sell those shares at $340. That’s true no matter how low AAPL may be trading. You have complete protection (from the moment you buy he puts until they expire) for the sum of $10,000.

You don’t have to sell the shares. For example, if AAPL is trading near $300, you may prefer to sell the puts and collect $4,000 for each (they are 40 points in the money and worth 100 x $40 each). You pocket a profit of $30,000, which cushions most of the loss ($50,000) from owning AAPL shares.

The other good news is that you own the shares as well as the puts. So, if the stock continues its very strong performance, you can participate in every penny of any stock price increase. Do keep in mind that if the stock is not at least 10 points higher in April than it is today, that you will not have made any money on owning the shares. But that’s not so bad. After all, you did purchase insurance and there’s a ton of value in feeling safe.

Bottom line: For $10 per share, you get good protection that lasts for 65 days.

Selling covered calls

If you are willing to settle for less protection (and that means getting clobbered if the stock moves under $300), and if you prefer a higher probability of earning a profit, albeit a limited profit, then selling calls is the right approach.

For example, you can sell the AAPL Apr 365 calls and collect $920 for each option. Collecting $9,250 (for selling 10 calls) is better than paying $10,000, but your protection is much less.

When April expiration arrives, the only ‘protection’ you have is the $9.25 per share that you received as premium when selling the calls. Thus if the stock declines by more than that amount, you would not make any money between now and that day in April.

However, this is important: If AAPL is $340 and you bought the put, you not only lose $10 per share from a decline in the stock price, but the put becomes worthless and you lose the $10 per share paid for that put. Total loss: $20,000. If you sell the call option, you lose the same $10 per share from the change in the stock price, but you keep the $9.25 collected when selling the call. Result: You lose $75.

It’s very attractive to choose the play in which your loss is only $75 instead of $20,000.

But, that misses the bigger picture. If something unlikely occurs and AAPL falls to $250, as a put buyer, your loss is still that $20,000. However, if you were the call seller, you would lose $90,000 when the stock falls by 90 points, and that $9,250 you collected will not feel like much of a consolation.

Similarly, if AAPL does what AAPL does and rises to $420 per share when April expiration arrives, the put buyer earns the full $70,000 as the stock move 70 points higher. Subtracting the cost of the puts, that’s an increase in value of $60,000. On the other hand, the call seller is required to sell shares at the strike price, or $365 per share. That gives her a profit of $15,000. Add to that the call premium and she earns a respectable $24,250. Respectable, but far less than the put buyer earned.

Thus, it comes down to this: Both buying puts and selling calls give you protection.

Buying puts works best when the stock makes a big move. It shields you from the big loss and allows you to prosper on a big gain.

Selling calls works far better when the stock does not take a big move. The truth is that the smaller move is far more likely than the bigger move. that makes the call sale look more attractive.

Ruth, it’s not a simple choice. However, if you want big protection, there is no substitute for owning puts. It you just want a small amount of protection and are not afraid of the downside, then selling calls works. From the tone of your question, I believe that put buying will work better for you. Not cheap, but it is excellent insurance against a disaster.

898

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2 Responses to Protection: Buy puts or sell calls

  1. Ed Hwong 02/11/2011 at 12:15 PM #

    RE: content for Options for Rookies Premium. May be already planned, but I’d find a complete life-cycle of Track a Trade for differing strategies to be the most useful. Including the pre-screening/selection process of the underlying or the option, to the entry point, to the trading plan w/ focus on risk management, as well as commentary or Q&A re: the tools or trading platforms being used (e.g. stop loss/limit orders in place, contingent orders of certain type, etc). Although the risk management may be dependent on each person’s personal risk tolerance, it would be great to make the criteria explicit for discussion. Thanks for the stimulating and educational content.
    Regards.

    • Mark D Wolfinger 02/11/2011 at 2:18 PM #

      Ed,
      Your comment contains some important points that I must stress, and I’ll provide a reply as a full blog post.

      Right now, I’ll tell you that I plan to do most of what you suggest. However, the goal of he premium site is EDUCATING members, not recommending winning trades.

      Thanks for comment