Wrinkly Dollar

Using Put Options to Hedge Against a Stock Market Decline

April is Financial Literacy Month. In following effort to highlight financial education, the following describes some of the basics of stock options.

For some people, investing is as simple as buying and selling common stocks through their broker. But there are many more vehicles that one can use to take advantage of investment opportunities. Put options on common stocks are among them, and when used properly, can allow increased exposure to or protection against stock prices.

Options explained

An option is a contract that gives you the right to buy or sell some asset at a predetermined price. We’ll focus on stock options. Let’s start with some terminology:

• The “asset”, in our case, the stock of the company we want to buy, is called the “underlier”.
• A “call” option gives you the right to buy the underlying stock.
• A “put” option gives you the right to sell the underlying stock.
• The predetermined price is called the “strike price”.
• Options have expiration dates attached to them. For US stock options, the expiration date is always the third Saturday of the expiration month.
• In the US, 1 option contract gives the owner rights to 100 shares of the underlying stock.

Think of an option as a piece of paper. With it, you could go to a broker or any other party and say, “I have this call option that allows me to buy 100 shares of GE stock at $10. It expires near the end of June. Today, it’s April 22, and GE’s stock is trading at $11.80.” The broker can buy GE stock in the market for $11.80 or he can buy your call option from you, and then go buy GE stock for $10. So, he’d be willing to pay you at least $1.80 for the option, it’s “intrinsic value”. But, the option doesn’t expire for another 2 months! What if GE’s stock rises in that time? The option to buy at $10 could be worth much more. Therefore, the broker should be willing to pay a little more than $1.80, to compensate you for this extra “time value”. In the end, the broker should be willing to pay $1.80 plus a bit more for your call option. (The concept of paying for possible movements in price is the crux of the broader financial concept of “optionality”. We’ll leave the specifics of “time value” for another article.)

In purchasing any option, the buyer specifies 5 things:

1. Is it a put or call?
2. What is the underlier?
3. What is the strike price?
4. What is the expiration?
5. And of course, what price will you pay for the option?

From our example above, the broker would be buying June GE calls at $10 for, say, $2.40.

How puts can be used

Just as calls give you the right to buy stock, puts give you the right to sell stock. It doesn’t matter whether you own the stock or not. Remember, think of the put option as a piece of paper that gives you the right to sell. If we owned a put on GE stock, someone out there would be willing to pay us money in exchange for the simple right to sell it at a different (higher) price than the market price, regardless of whether we own the stock or not.

Let’s imagine for a second that we own stock in GE, but we are fearful that the stock may drop in price in the near term. One thing we could do is sell the stock, but that may not seem appealing if we want to hold it for the long run. Another option is options! We could buy a put on GE. We would still own the stock, which would drop in value if the market price dropped, but we would also own the put, which would rise in value as the stock’s market price fell.

For example, suppose we own 100 shares of GE and the current price as of April 22 is $11.80. We are fearful that the price will fall in the coming months. We purchase 1 put contract on GE for December expiration at a $12 strike for $2.50. This $2.50 price represents $0.20 of intrinsic value and $2.30 of time value. Suppose the price of GE falls to $5 before the end of December rolls around. Out stock has lost $6.80 in value, but our put options are worth $7 plus any time value remaining, after we paid $2.50 for them.

Let’s compare our per share loss with and without the puts:

• With the put option purchase: Loss = $7 – $2.50 – $6.80 = -$2.30, the original time value of the option
• Without the put option purchase: Loss = -$6.80, the loss on the stock

As you can see, purchasing the put options is like buying insurance. Should the stock fall in price, our losses are capped at the original amount in time value that we paid for the put option. If the stock rises in price, we still experience the upside in the stock’s value (since we own 100 shares) minus the $2.50 per share we paid for our put options. We can summarize our per share profit or loss based on the stock’s final market price (when we sell our options or when they expire in December):

• Final price <= $12: Loss of $2.30
• $12 < Final price < $14.30: Loss of $2.50 – stock appreciation
• Final price >= $14.30: Profit of stock appreciation – $2.50

We have protected ourselves against any downside in GE’s stock price without selling the stock, and we have done so while retaining the upside, all for the price of $2.30, the original time value of our put option.

Getting naked

You can also use puts for speculation or as an alternative to shorting stocks. Whenever an investor purchases or sells options without having a position in the underlying asset, the option is described as a “naked” one. Let’s assume that I believe the stock market in general will suffer declines in prices for some time. I could purchase puts on the S&P 500 to profit from the decline. As the general prices of stocks sank, the price of my put options would rise. I’ll note here that purchasing puts directly on the S&P 500 is not possible, but you can purchase puts on a vehicle that replicates the S&P 500 and achieve the same effect. One such vehicle is S&P Depository Receipts.

Buying puts may be a better alternative than outright shorting for the novice investor who believes market prices will fall:

1. Shorting stocks leaves the investor with unlimited downside should market prices rise. The downside when buying puts is simply the original price of the puts.
2. Most brokers require a margin account (one approved for borrowing) in order to short. In buying puts, the investor is required to have the cash upfront.
3. Buying puts can amplify returns compared to shorting when large price changes in the underlier occur.

Buying puts can be a good way to hedge yourself against downside in the prices of stocks you own. It can also be an effective way to profit from market downturns that you believe may occur.