A friend and I have actively discussed how best to position ourselves for the near-term, bearish risks in the market. As my favorite technical indicator, T2108 – the percentage of stocks trading above their 40-day moving average (DMA), hit oversold territory, he asked my opinion about adding to his SSO put spread. Puts on SSO have formed the core of my own bearish bets, but given the oversold technical conditions, it did not make sense to me to buy fresh puts unless they are used for downside protection and not to make money.
My astute friend quickly challenged me on the notion of buying puts for protection versus for profit. After all, we trade to make money, right? I provide below the explanation that makes sense to me:
SUMMARY
Puts purchased for protection are out-of-the money with as short a duration as needed to cover the perceived risks. Minimization of cost is important given these costs eat into the eventual profits one expects to make on the underlying shares. If the feared risks never materialize, the overall position makes money from the underlying shares while the puts go to zero. Thus, the best outcome is a bullish one.
Puts purchased for profit have strikes that are closer to the current stock price. Costs are finely tuned to the perceived profit potential (risk/reward) and leverage applied to the trade. All risk is packaged within the puts given there is no underlying to protect. If the feared risks never materialize, the overall position loses money (likely everything). Thus, the best outcome is a bearish one.
I find it easiest to define “puts for protection”:
Identify the specific risk factors that cause concern and buy just enough puts for just the amount of time the risks appear greatest. Puts should expire shortly after the feared event. Buying for a longer period of time does not make sense because of the extra time and risk premium this will cost. Since the position will include the underlying shares, a trader or investor assumes that the eventual (or longer-term) prospects are bullish. Otherwise, immediately sell the underlying position.
The puts are out-of-the-money because it is only the out-sized and unexpectedly negative reaction that could cause enough loss to force the trader or investor to deviate from the overall plan. In other words, the puts are positioned such that the overall risk in the underlying is capped at a “manageable” level, and the puts are selected to minimize overall cost.
If the perceived risk is at the macro-level, like a new bear market, then clearly the time horizons on the puts have to extend further. The trader or investor will also have to create a strategy for rolling the protection periodically since the timing of such a large event will always have a wide band of uncertainty.
I find defining “puts for profit” to be a lot more squishy:
The clearest component of this strategy is the lack of underlying shares (hedging strategies are a big exception). Moreover, the trader or investor requires the perceived risks to materialize to avoid losing money.
For example, what happens if a trader expects the market to sell-off in the next three months? The trader can choose to sit out the market to wait for the risks to play out over this time, or the trader can transform this risk into an opportunity by buying puts now. To make money, the trader needs to cover the uncertainty of time and depth. The chosen puts must expire a little later than the duration of the perceived risk. The chosen puts should also not be out-of-the-money so that profits can accrue even if the correction is not as deep as expected (nothing worse than being directionally correct with nothing to show for it). If the correction gets steeper, the trader can always lock in profits on the original puts, and apply those profits to puts with lower strikes (and start riding on the “house’s money.”)
The further the expiration goes in time, the more likely a put spread becomes the trader’s best choice. While it tightly caps overall profits, it also greatly reduces the cost of time premium which can destroy the profit potential of a trade if the puts are far out in time. The trader achieves good risk/reward by selecting a strike price for the short side of the spread around the downside target generated by the perceived risk.
For example, if on expiration day, the underlying hits the strike price of the short side of the put spread, the trader realizes the full potential profit of the spread. This scenario is the best case. The short side of the spread goes to zero, and the end result is the same as having bought just the long side of the put – with much less risk. A trader can also choose to cover the short side if the market moves strongly against the position on the way to the downside; this strategy increases the profit potential with a small extra cost.
To learn more details about trading options, I strongly recommend perusing Schaeffer’s Research. Bernie Schaeffer founded this site and is the author of the most well-read book on options: The Option Advisor: Wealth-Building Techniques Using Equity & Index Options (A Marketplace Book)
. One of my favorite books on options strategy is Options as a Strategic Investment
. It is the most comprehensive book I have read on the subject of options trading.
Be careful out there!
Full disclosure: Long SSO puts