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Should I buy a call or sell a put?

The title question was submitted by a TradeKing customer and the video reply is posted at their web site.

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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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