From free introductory classes to advanced trading strategies, we aim to help you increase your knowledge and trade smarter. Let's make investing easier and not alone.
-Moomoo News Team
Professionals believe that the only way one can safely be in the market for the long investment is by being hedged. Put options can be used as an insurance policy to protect stock or mutual fund holdings.
As a good rule-of-thumb, when you buy stock or mutual funds, you should buy puts. Buying puts to hedge a stock position is referred to by the professionals as "married puts." You should buy enough puts to cover your long stock position. (Remember, one put contract gives the holder the right to sell 100 shares of the underlying stock, at the strike price, before the expiration date.) By purchasing puts, you minimize the potential loss on a stock or mutual fund, should it decline in price.
For Example: You buy or own 1,000 shares of XYZ at $31 plus ten $30 strike puts expiring in one month from now with $1. By purchasing the put, you have increased your investment in XYZ to $32.($31 for the stock itself + $1 for the options hedge)
Buying puts for protection is obviously a bullish strategy. If you thought a stock was going down, why own it. However, you don't mind paying insurance for something you feel will continue to go up in value. Therefore, it is important to understand that buying married puts is not a cure for poor performing stocks. If you own a stock that is not going up, why do you continue to own it? Sell it, and buy one you are confident will go up, along with a married put, in case you're wrong!
With married puts, you should be confident that the stock will increase in price and also be willing to give up a little upside profit to offset your downside risk protection. By purchasing puts, you set the maximum loss on the stock at the put strike price, less the cost of the put. In our example, you are guaranteed $29 for the stock (the put strike of 30, less the $1 premium paid for the put) even if it goes to zero prior to expiration.
The options of the married-put holder:
Should your stock decline in price, you have two options as a married-put holder:
1. You can exercise your right to sell the stock at the put strike price.
2. You can sell the put option and keep the stock and then re-hedge the position with another put. You will then own the stock at the current price, but the sale of the put option will give you the difference between the put strike price and the current price of the stock, plus any remaining time value in the put.
The advantage of buying puts over stop-loss orders:
Stop loss orders are poor protection against sudden downturns in a stock. Bad news, poor earnings, political problems, and many other factors can cause a stock to gap down. In our example, should the stock gap down from 31 to 20, a 30 stop loss order would sell the stock near 20 not at 30 since the stock never hit a price between 30 and 20. If you have a 30 stop order once the stock hits 30 or below, the stock is immediately sold at the market price. If you had a "stop limit order" at 30, you wouldn't be sold until the stock goes back to 30.
However, the stock could continue to drop. Stop and stop limit orders, therefore, provide very little protection. But, if you own the 30 strike put, you have the right to sell the stock at 30 any time prior to the option's expiration. A stop-loss order can also force an untimely sale. When a stock price reaches the stop, it is sold automatically; thereby eliminating the chance of participating in upward movements should the stock turn around. Owning the puts allows the holder to ride out these downturns.
Editor: Eli
For more investment knowledge and trends, welcome to Courses in the Community.
