Puts for Protection – Follow-up

In an earlier article about using puts for protection, I used an example of using a put option to achieve a desired level of protection of a position on SPY, the exchange-traded fund that tracks the price of the S&P 500 index.

The position consisted of 100 shares of SPY which had been purchased around September 13 at a price of $289. Here’s what I said about the position at that time in a very small nutshell:

The example we used was buying a put as protection for a position of 100 shares of SPY, when SPY was trading at around $289 per share. Our goal was to limit our loss to no more than 10% of the value of SPY, over a 6-month period of time. We used a put at the $265 strike price that expired six months out, in March 2019. The puts at that time could be bought for $4.96 per share in lots of 100 shares each, that is $496 for each put.

How did that put protection work out?

Well, as of the close on December 24, the price of SPY had dropped from $289 to $234.34. This was a drop of 18.93% in 3 months, on pace to be the worst quarter for the market since the Great Depression. The price of SPY had dropped below our $265 put strike by almost $30 per share.

Did the put limit our loss to no more than 10%, as it was designed to do?

In fact, it did, performing exactly as expected.

In the diagram below, the top chart is that of SPY over the time period examined, showing its 18.93% drop.

The middle chart shows the value of our March $265 put, originally purchased for $4.96 per share, which had increased in value to $30.85 per share.

The bottom chart shows the combined value per share of the SPY together with the $265 Put. That combined value had declined from $294.01 (the SPY value of $289.05 plus the cost of the put of $4.96 per share), down to $265.19. A drop of $28.82 net.

If we had wished to completely liquidate the position at the time of the graphs, we would have a loss of $54.71 per share on the SPY stock; and a gain of $25.89 per share on the $265 puts, realizing our then-current net loss of $28.82 per share. That loss of $28.82 was almost exactly 10% of the original SPY price. So, we had achieved our goal of limiting our loss to no more than 10%, and our loss could not possibly grow any further, no matter what happened next.

Note that there was no need to liquidate our position at this time. The point of using a put option instead of a stop-loss order is that with the put we were protected against any further loss, but we could still participate if SPY recovered before the put expired. We could simply now continue to hold the SPY position, together with the put, to await further developments. If the market did bounce back, as it did in 1931, then by March SPY could very well be higher than when we started, erasing our loss altogether!

But, what if instead of recovering SPY were to continue to drop? What if 2018 turned into 2008 and we were just getting started on another 52% drop?

In that case, up until the March 15 put expiration, we would never be any worse off than we already were. In other words, we had met our deductible, so to speak, and our loss could never grow beyond the 10% we had already incurred. At this point, the Delta of our put was at its maximum of -100%. This meant that from there on, no matter how far SPY dropped in value, the put would gain exactly the same amount as the SPY lost, dollar for dollar, completely offsetting any further loss. This would be true even if the value of SPY dropped to zero.

So where did we stand?

• Despite a drop in the underlying market of about 19%, our loss was limited to only the 10% that we had initially decided was to be our maximum risk.

• We had another three months in which our position could improve. Not being stopped out, we could benefit from any upward move.

• Our position could not worsen in that time, no matter how much the market might drop.

• In other words, our insurance passed its stress test and worked as expected.

Using puts in this way is just one of many money-saving and money-making strategies that options offer. Inquire about our Professional Options Trader program at your local center.

Read the original article here - Puts for Protection – Follow-up

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