With a volatile market, a fear on everyone's mind is committing new money to the market.
The worry is that what you invest today may lose 5% or 10% if the market declines.
How can you avoid this, but still commit money to the stock market?
One possible approach to limiting downside risk is to buy a put option at the same time you purchase your stock. The put is bought at the same strike price as your purchase, leaving only the premium of the put as your expense. The put gives you the right, but not the obligation, to sell your shares back to the writer of the put at the strike price.
If the feared decline occurs, you have two choices: exercise the put, or sell the put. If you exercise the put, you sell your stock and your entire investment is returned to you. The cost of the put is your true loss and you're out of the market. If you sell the put, you can recover all of your loss on the stock investment, plus whatever premium is still in the put, but you remain exposed to risk since you are still holding the stock.
Here's how it works.
For the stock purchase, first determine if options are available. Next figure out the price of the put option closest in strike price to the current price of the stock. Often there will be several time durations available.
Pick the time period with which you are comfortable. Just like insurance, the longer you want the protection, the more it costs.
Before this strategy, you should calculate on paper on the following items:
1) The total cost of your investments: This is the stock and the price of the put. We have left out commissions in the calculations below, but include them if you can.
2) How high the stock must rise to cover the cost of the put. Take the total price for the put, add it to the total price for the stock, and divide by the number of shares of stock. This is your breakeven point. If the stock rises to this point, you have paid for the price of the put. Of course, if the stock rises to this level before the put expires, there may be value still left in the put.
3) Your target price and time period for the stock. Obviously, this price must be higher than your breakeven point for the strategy to be profitable.
4) Calculate the return during this time period with and without the put. Make a subjective judgment as to whether the tradeoff in return is worth the reduction in risk.
For example, here are the above calculations for IBM, using actual numbers from a recent close.
|IBM Common||(IBM)||120 11/16|
|September Put at $120||IBMUD||4|
|October Put at $120||IBMVD||6 1/4|
1) Calculate the total cost: 100 Shares IBM @ 120 11/16 = $12,068.75
Plus: 1 Contract September 120 Put @ 4 = $400 or:
Plus 1 Contract October 120 Put @ 6 1/4 = $625
1b) Total Cost is $12,468.75 for the September protection, and $12,693.75 for the October protection.
2) Calculate the breakeven point: IBM stock must rise to $124 11/16 to break even. For the October protection, IBM must rise to $126 15/16.
3) Know your target price: For the purposes of example only, (not to be construed as a Briefing target for IBM) let's use a target of $130 by September 18 and $140 by November 16.
4) Calculate the return: For the September put strategy, your potential profit is $531.25, or 4.2% with downside risk of $400, or 3.2% Without the put, your potential profit is $931.25 or 7.7% with no downside protection. Limiting your downside risk to 3.2% costs you 3.6% return in this example.
For the October option, your potential profit is $1,306.25, or 10.3% return. The downside risk is $625, or 4.9%. Without the put, your potential profit is $1,931.25, or 16%. Limiting your downside risk to 4.9% costs you 6.3% of reward.
In both of these examples, we assumed the option expired and was worthless. In reality, it is likely that you could close the option position for a small amount of return prior to expiration.
Additionally, the example above is what it costs to totally eliminate downside risk. It can be considerably cheaper to simply reduce downside risk. The same calculations methods can be used for partial coverage or for accepting a certain amount of downside risk.
Are these tradeoffs worth it? That's completely up to you. If you feel that the real risk is a catastrophic collapse, and not a gradual decline, but you believe the market will climb if the catastrophic collapse is avoided, you may wish to consider put options as hedges
Note: Briefing.com provides these comments as explanatory material for our readers. This does not guarantee that you will make money. If stocks decline, you will still lose the cost of the put. If the put expires without selling or exercising it, you lose the total premium paid for the stock. Expiration of the put means that any protection you have is also gone. If you do not have experience trading puts, we highly recommend that you practice with paper trades before placing a real trade with real money.
Robert V. Green