I'll try to help with the options strategy of protective puts.
Using an example from early March. Say for example you purchased a stock that had a pretty good runup in the Dec-Mar rally, like EMLX. You purchased your stock (1000 shares) on Dec 1, 99, for $78 (adjusted for split). You've seen the thing blast off, bust out a gain far better than you expected, and it looks like you'll be sipping Mint Julips on the beach in Aruba in no time! But the contrarian in you keeps watching CNBC in March and with all the pundits jabbering incessantly of "convergence day" (the day when the DOW and the NASDAQ will have the same composite score), you think this whole NASDAQ thing is a train wreck in the making. So the skeptic in you, wanting to lock in some gains, but not wanting to miss any upside potential, decides to take out a little insurance policy. You call up your broker and get a quote on buying the April puts, strike of 160, just in case this thing does tank. Now, options, being a wasting asset, have little things besides just "beta" and "alpha" determining their intrinsic value, so the quote comes back at 7/8 for the puts. Buying puts are normally FAR cheaper than calls in a strong bull market, remember this. So you put in a market order for 10 options on the April 160 puts. It takes, at 1 1/2, (your broker tells you that the "gamma" changed the "delta," that's why the price went higher...yeah, whatever) and you pay the $1500 premium. Mind you, your 1000 shares have given you a paper gain of over $100,000 by mid March, so the $1500 is a drop in the bucket. (call it increasing your basis price by 1 1/2...now sitting at 79 1/2, no big deal) Now, just as you thought might happen, your beloved little stock dropped faster than the pants at a brothel. Ahh, but you have a trump card, while your stock was tanking, the value on the put was taking off like a rocket ship. It went from a value of 1 1/2 to now worth over 120 (remember that "gamma" thing your broker mumbled?, it swings both ways), as of Apr 15. Your long position is now worth only $45,000,for a paper loss of $33,000 (excluding the option premium), but your option just made up your "insurance policy" to the tune of $120,000. Net profit of $87,000 if you cash out now. Now, if you just bought the stock (no options) at 78, sold at 160, and expected to buy the stock back later at a cheaper price, you would have locked in your $82,000 profit, and had to try to "time" the market to get back in. Now, knowing EMLX like we do, most people would have seen it climb back up to over 200 and bought it back, getting greedy chasing it, and cursing the $40/share they "lost," at exactly the WRONG time. (It's that individual investor psychology thing) So, the underlying assumptions here are that nobody can time the market perfectly, buying puts are normally a lot cheaper than calls, and if we have a good paper gain on stock, we can use the put to "protect" our gains. If the stock DIDN'T tank, all you would have been out was the $1500 premium for the put, and there would be no limit to your gain on the upside. So, like any insurance policy, you curse it when you pay the premium, but thank your lucky stars if you ever need it. Now, in the case of a Mutual Fund, there are requirements for most of them to be fully vested at all times (very little or no cash). Buying the puts might be their only option (no pun intended), even if they "know" the market will tank.
Now, like Gene said, if it's for a retirement account, you'd be better off with blue chips and index funds as your core holding, but you should still set aside a small percentage of more speculative issues, and averting risk is where the protective puts come in. They beat the heck out of watching helplessly as an individual stock tanks. A market crash takes no prisoners. The one in April is a prime example. At one point it lost 11% in 3 hours of trading. There were NO buyers.
It's only slightly more complicated than this quick overview, but remember, hindsight is always 20/20, and looking at a chart and saying, "I could have bought it here and sold it here" doesn't work in real time. If you have the knack to "time" the market perfectly, call that luck and nothing more. Your luck WILL run out. As for me, I'm not that good, much as I try. I'll humbly keep using the options as a hedge. |
