Buying Temporary Portfolio Insurance
The first conservative strategy involves using options to ensure profits in a specific stock. Most people understand the proper use of insurance. You pay a premium to buy protection against loss. If the loss occurs, the insurer reimburses you. If the loss does not occur, the insurance premium is viewed as a cost of protection against the risk, a means for offsetting the exposure.
A put option can be used in this manner to protect a profit. A put is a contract that provides you the right to sell 100 shares of stock at a specified price by a specified expiration date. That price is unchanging, so that if the market value of stock falls below that price, the put has ensured the price level you target. Even long-term investors may run into situations in which a relatively short-term paper profit is worth protecting.
Example: You bought 100 shares of stock last year at $32 per share. The price remained in a fairly narrow trading range until last week, when it suddenly rose to $43 per share. You cannot find any immediate reason for the sudden change in price, and you suspect that the price will correct itself in the near future. You can buy a "40 put" (meaning the right to sell 100 shares of stock at $40 per share) for $200, and that put will not expire for three months.
What happens in this situation? Consider the three possibilities: the market price rises, the market price remains the same, or the market price falls.
1. The market price rises. If the price continues to rise between now and the option's expiration date, then you have given up
202 Mastering Fundamental Analysis
$200 for the protection of the put. You lose that $200 when the option expires. The loss can be deducted on your income tax return as a short-term capital loss. Meanwhile, the rising stock remains profitable.
2. The market price remains the same. The outcome is the same as above. You gain nothing from the option insurance because you lose no market value in the stock.
3. The market price falls. This is the situation in which the put provides price protection. Because the contract provides that you can sell 100 shares at $40 per share, the put becomes more valuable as the stock's market value falls. This does not mean you have to sell the stock. It only means that you have insurance in the event that the stock does fall. If, for example, the value of the stock fell back to $35 per share before the put's expiration, that put would increase in value point-for-point below $40 per share. So you could take one of two actions before the expiration date. First, you could exercise the option, enabling you to sell 100 shares of stock at $40 per share. In that case, your profit will be $600 (before deducting trading fees). That is a 100-share computation combining stock and option transactions:
Option exercise price of $40 per share $ 4,000
Less: purchase price of stock, $32 per share - 3,200
Less: option premium - 200
net profit before trading fees $ 600
The second strategy achieves approximately the same benefit, but without forcing you to sell your stock. After all, if you still believe that the long-term prospects for the stock make it worth holding, the real purpose of the put insurance strategy is to get the profit without giving up the stock. Remember, the put will become more valuable as the stock's market price falls. Using the same example as above, we assume that the stock's price fell to $35 per share. Right before expiration, the put will be worth $500—one point for each point difference between current market value and the put's specified price. That means you can sell the put at $500.
In this case, your profit (before trading fees) is $300, the difference between your sales price of $500 and your original purchase price of $200. Thus, by using a put for insurance, you make a $300 profit and still own the stock. This means that while you originally purchased the stock at $32 per share, the profit from buying the put reduces your basis to $29. The profit is reported as a short-term capital gain for federal tax purposes. Depending on the rales where you live, state income tax might be payable as well.
This illustrates the purpose of a put option used for insurance. It provides partial protection for a momentary profit. This is not a common situation, but it can occur. As a long-term strategist, you should not be looking for opportunities to buy puts, but when extraordinary situations arise, puts can be used to protect your profits.
KEY POINT
Buying puts is acceptable if done for the purpose of ensuring a profit position. This is not the same as speculating as an option buyer.
