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Simple, Straight Talk on Put Options

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Hedging Your Bets — Put Options

Con­ven­tion­al wis­dom sug­gests that “hedg­ing your bets” is pru­dent.  This con­ven­tion­al wis­dom is espe­cial­ly true in sit­u­a­tions where the biggest risks lie out­side your con­trol:

  • A farmer might hedge his bets by lock­ing in the sales price of his crop.
  • An air­line might hedge its bets by lock­ing in the price for their fuel.
  • A com­pa­ny might hedge its bets by lock­ing in the dol­lar exchange rate if it has over­seas oper­a­tions.

With all of these actions, the goal is to man­age the big, exter­nal risks that could ruin the farmer, air­line, or com­pa­ny.

Con­sid­er­ing stock mar­kets are trad­ing near all-time highs, investors might won­der how to “hedge your bets” in their port­fo­lios. With many invest­ments, hedg­ing can be accom­plished with the use of put options.

There are many invest­ment strate­gies that hedge the mar­ket, and many of them use put options to do so. If one were to look up the def­i­n­i­tion of “put option,” the offi­cial def­i­n­i­tion is:

A put option is an option con­tract giv­ing the own­er the right, but not the oblig­a­tion, to sell a spec­i­fied amount of an under­ly­ing secu­ri­ty at a spec­i­fied price with­in a spec­i­fied time.” (Source: Investo­pe­dia)

Huh?”

Can I get that in plain Eng­lish please?”

 

Straight Talk on Put Options

Basi­cal­ly, a put option allows some­one to “lock in” the sale price of an asset. If some­one owns a put option, they can force some­one else to pur­chase an asset at a set, pre-defined price.

That agreed-upon price is known as the “strike price” and is defined in the option con­tract.

The actu­al mar­ket price of that asset might end up being sig­nif­i­cant­ly low­er than the strike price, but the put option has locked in the sales price.

 

Put Option — Falling Stock Price Scenario

There are two sce­nar­ios that are impor­tant to con­sid­er at this point: falling stock price vs. ris­ing stock price.

Let’s look at the fol­low­ing ‘falling stock price’ exam­ple:

Assume the stock in XYZ Corp is trad­ing for $100 per share on Jan­u­ary 1st. Some­one decides to buy a put option with a $100 strike price and a three month expi­ra­tion. Then, let’s assume by March 31st the price of XYZ Corp’s stock has fall­en to $60.

 

Put Option - Falling Stock Price | Straight Talk on Put Options - Swan Blog

 

The own­er of the put option has locked in a sales price of $100, even though the mar­ket price of XYZ is only $60.

Some­one else has to pay him the full $100 for XYZ stock.

Not bad! That’s a dif­fer­ence of $40.

Of course, it goes with­out say­ing that put options are not free. In the sce­nario above, the hold­er of that put option might have paid $5 for his three-month put option on XYZ on Jan­u­ary 1st. That out-of-pock­et cost would reduce the prof­it from $40 to $35 in the above sce­nario.

 

But what if the price of XYZ stock goes up, rather than down?

What if over the next three months the price of XYZ ris­es from $100 to $125 per share?

Put Option  — Rising Stock Price Scenario

Put Option - Rising Stock Price | Straight Talk on Put Options - Swan Blog

 

 

Again, the put option gives the investor the chance to sell XYZ for the locked in price of $100. But the mar­ket price is now $125! The investor could sell XYZ on the open mar­ket and col­lect $125. The fact that he has a put option at $100 is now irrel­e­vant and the put option, at expi­ra­tion, is worth­less.

Back in Jan­u­ary, the investor did not know if XYZ was going to go up or down, but he had to pay that $5 pre­mi­um to pur­chase the put option regard­less. The hold­er of the put option hopes that XYZ falls far enough so that the gap between the strike price and the mar­ket price is at least enough to cov­er the $5 out-of-pock­et costs he had when pur­chas­ing the put option. If that gap is larg­er than $5, then the remain­der is all prof­it to him. How­ev­er, if XYZ is flat or ris­es, then the option will even­tu­al­ly expire and the investor will be out $5.

It should be not­ed that all options even­tu­al­ly expire. Some expire after only a week, some might have expi­ra­tion dates going out for two or three years.

The time to expi­ra­tion impacts the price some­one might pay for an option. Gen­er­al­ly speak­ing, the longer to expi­ra­tion, the more valu­able the option is since there is more time for a move to occur.

So why would someone want to own a put option? 

There are two pri­ma­ry rea­sons for own­ing a put option.

  1. spec­u­la­tive pur­pos­es
  2. hedg­ing pur­pos­es

1 — With a spec­u­la­tive posi­tion, some­one is tak­ing a bet.

Maybe Steve the spec­u­la­tor has a very bear­ish view on an asset and wants to prof­it if the price were to fall. Steve is look­ing at our pre­vi­ous exam­ple and thinks XYZ is over­val­ued at $100. Steve thinks it is only a mat­ter of time before XYZ’s stock drops. If Steve believes that will hap­pen with­in three months, he can pay the pre­mi­um (in the pre­vi­ous exam­ple, $5) for a put option.

If Steve is right and the stock falls with­in the three-month win­dow, he can prof­it from XYZ’s fall. In fact, the more XYZ falls, the more prof­itable his bet becomes. If XYZ doesn’t fall, well, the $5 pre­mi­um Steve spent is now a sunk cost.

2 — Alter­na­tive­ly, put options can be used for hedg­ing pur­pos­es.

Hedg­ing can be thought of as pur­chas­ing pro­tec­tion, e.g. a pro­tec­tive hedge.

Say, for exam­ple, Heather the hedger is a life­time employ­ee of XYZ Corp. Heather has spent her entire career at XYZ and has amassed a healthy amount of XYZ stock. Maybe 90% of Heather’s wealth is tied up in XYZ and she is approach­ing retire­ment. What should Heather do? She doesn’t want to sell her stock because she feels a cer­tain loy­al­ty to XYZ and she would also get hit with a big tax bill. On the oth­er hand, maybe XYZ’s stock has been volatile of late and Heather doesn’t want to see her wealth drop by 25% or more just as she’s about to retire.

In the above sce­nario, Heather can hedge her XYZ by pur­chas­ing some put options on her XYZ stock. She locks in a sales price for XYZ. Obvi­ous­ly, she hopes that XYZ con­tin­ues to go up, but in case XYZ goes down, she can set a sale price to pro­tect against cat­a­stroph­ic loss­es. Of course, Heather will have to pay for this hedge. Put options are not free and they do expire, so her hedg­ing strat­e­gy will require her to pay to main­tain pro­tec­tion on her XYZ stock.

 

Hedging is Similar to Insurance

In a way, a port­fo­lio hedg­ing strat­e­gy is a lot like pur­chas­ing insur­ance for the port­fo­lio.

Peo­ple buy home, auto, health, and life insur­ance to pro­tect against cat­a­stroph­ic loss­es. Insur­ance poli­cies have a cost to them, also known as a pre­mi­um. Insur­ance poli­cies are also typ­i­cal­ly valid for a set amount of time — usu­al­ly three months, six months, or a year.

If the insur­ance poli­cies are not used, they have to be renewed and a new pre­mi­um has to be paid in order to main­tain cov­er­age.

Cer­tain­ly, if some­one opt­ed not to car­ry insur­ance, they would have a lot more dis­pos­able income. How­ev­er, the risk of a major, life-chang­ing cat­a­stro­phe is usu­al­ly more risk than most indi­vid­u­als are will­ing to bear. So most peo­ple will­ing­ly give up a por­tion of their income to pro­tect what they have.

A hedg­ing strat­e­gy using put options has sim­i­lar goals.

Hedging and the DRS

It is for hedg­ing pur­pos­es that Swan Glob­al Invest­ments uti­lizes long-term put options in the Defined Risk Strat­e­gy (DRS). The long-term put options used in the DRS have an expi­ra­tion date far into the future (usu­al­ly two years) and do not apply to a sin­gle stock, but for the entire mar­ket (as defined by the S&P 500). That way, if the mar­ket sells off in a major fash­ion, the DRS has “locked in” a sales price on the S&P 500.

The DRS is always invest­ed in the mar­ket via cost-effi­cient ETFs, but that buy-and-hold posi­tion in the mar­ket is always hedged to pro­tect against major sell-offs by the intel­li­gent and effi­cient use of put options.

Final­ly, it should be not­ed that trad­ing options is not for ama­teurs. There are rules and reg­u­la­tions relat­ed to trad­ing options in per­son­al accounts. One must prove them­selves knowl­edge­able about options before most cus­to­di­ans will let them buy or sell options. It is the opin­ion of Swan Glob­al Invest­ments that man­ag­ing options is a job best left to pro­fes­sion­als.

To learn more about Swan’s Defined Risk invest­ment approach or for more details regard­ing his­tor­i­cal per­for­mance uti­liz­ing put options to hedge a port­fo­lio since 1997, please con­tact Swan at 970–382-8901.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

 

Impor­tant Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results, and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. Eco­nom­ic fac­tors, mar­ket con­di­tions, and invest­ment strate­gies will affect the per­for­mance of any port­fo­lio and there are no assur­ances that it will match or out­per­form any par­tic­u­lar bench­mark. There­fore, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains.  This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it swanglobalinvestments.com.  278-SGI-111016[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

By | 2017-08-21T14:19:47+00:00 November 17th, 2016|Blog|Comments Off on Simple, Straight Talk on Put Options