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This is definitely a market in which you need to be hedged. The S&P 500 and the Dow are down about 11% over the past month and only about 2% above earlier January lows. On the other hand, some stocks are doing better than others. Value Line’s rank 1 common stocks are down only about 3.5% as investors are tentatively looking for growth potential. In what may be a “stock picker’s” market, holding good stocks and protecting them with puts may be the way to go. In this week’s report, we cover in some detail how to hedge stocks you own with puts. Even when markets are volatile (as they are now), you can tailor your put insurance to suit your expectations and your tolerance for risk.

Insurance against Uncertainty

Buying a put to protect your stock is the most easily understood example of option buying as insurance. If the stock goes down sharply, the profits from the put will compensate you for any loss below the strike price and the premium you paid – even if the stock goes to zero. Thus, you are insured. But what exactly are you insuring against? The simplistic answer is that you are insuring against losing money. But that is not the whole story. If losses were all you were worried about, you would simply sell your stock.

What you are really insuring against when you buy a protective put? You are insuring against uncertainty. More specifically, you are insuring against making the wrong investment decision. Two examples of the wrong investment decision would be (1) to hold your stock and watch it go down or (2) to sell your stock and then see it recover. If you had protected your stock with the put, you can be right either way. That is – the stock can decline and your losses will be covered, or the stock can rise and you can enjoy some gains.

As we will show in the examples below, you can tailor your put insurance to suit your expectations of how the stock might perform as well as your tolerance for risk. On Monday, February 2, 2009, the Biogen-Idec (BIIB) stock was trading at around $50 per share, with the at-the-money April $50 strike put offered at $4.40 per share, the higher strike in-the-money $55 put offered at $7.40 and the lower strike out-of-the-money $45 put offered at $2.35.

In Figure 1 and Graph 1 on page x, we compare the outcomes at different prices on the April 18, 2009 expiration date; (1) leaving 100 shares of BIIB unhedged, (2) hedging these shares with the at-the-money $50 put, (3) hedging them with the out-of-the-money $45 put and (4) hedging them with an $55 in-the-money put. Notice that with the in-the money put, you suffer the lowest loss if the stock drops sharply, but you also have the lowest gain if the stock rises.

Buying Full Insurance

Which of these put options offers the maximum insurance? The instinctive answer is the in-the-money put because it protects the downside more than the other puts. But is this really the maximum insurance? After all, if you just wanted to protect against a loss, your best choice would be to sell the stock and hold cash. But then, of course, you would have given up the chance for any further gains in the stock. Really, when you think about it, buying the at-the-money $50 strike put at $4.40 is the maximum insurance. Why? Because if you are uncertain about the direction of the stock, and do not want to be wrong if the stock makes a big move in either direction, then the at-the-money strike put is the insurance you want to buy.

With the at-the-money put, if BIIB rises $15 by the April expiration to $65, the investor will have participated in all of the $1,500 gain in a 100-share stock position, but will be out the $440 paid to purchase the put on 100 shares. Alternatively, if the stock declines $35, all the investor will lose is the $440 premium, since coverage of the put will kick in when the stock is below $50 at expiration. A simple rule of thumb: if you expect a lot of volatility, but are uncertain about the direction, then buy the at-the-money put.

Deductible Insurance with an Out-of-the-Money Put

Suppose you were more bullish than bearish on BIIB, but wanted to cover your exposure should you be wrong in your expectations. In this case, you may want to hedge by buying deductible insurance in the form of the out-of-the-money put. Looking again at Graph 1, notice that if you buy the out-of-the-money $45 strike put at $2.35 ($235 for one option contract), your protection at expiration starts at this lower strike price. However, if the stock rises instead of declines, your gains will be a lot better than if you hedged by buying the at-the-money put.

When you hedge with an out-of-the-money put, you are essentially buying deductible insurance. The most you can lose on 100 shares covered with the $45 put in this example is $735, i.e. your $500 “deductible” (represented by the difference between the common and the strike prices) and the $235 you paid for the put.

In-the-Money: Another Type of Deductible

Buying the in-the-money put is also another form of deductible insurance, even though most people don’t see it that way. Note that with this $55 strike put at 7.40, $5 of the premium is actually tangible value and only $2.40 is time premium.

Here you are essentially selling off your stock, but insuring yourself against the wrong decision by retaining the right to some upside potential if the stock makes a really large upward move. At all prices below $55, you are out the option’s time premium of $2.40, since gains and losses on the stock and the option will offset each other. Above $55, you will start to reap profits. (Note this move is really quite similar in its outcome to selling the stock and then buying the April $55 strike call, which makes money only if the stock moves above the strike price.)

Looking for Puts for Hedging

If you have a portfolio of stocks that are unhedged and you are interested in buying puts on them, one of the things you can do is use our Options Screener to find the most favorably priced puts on these stocks. Simply type in the stock tickers in the box so marked and look for puts that meet your criteria (% in/out of money, expiration, etc.). You can find the most favorably priced puts by selecting in Buyer’s Under/Over Priced as your sorting field in Display Options and sorting these numbers in ascending order.

Other Reports on Hedging

Subscribers may also want to look at the following in our Options Reports archive on hedging their stocks.

Hedging with Collars: You can greatly reduce the cost of your put hedges by selling off some of your insurance by hedging with what is known as a collar. You can even sell your insurance in such a way that you actually take in time premium (Ot080915.Pdf).

Hedging with Bear Spreads: You can also hedge your stock with a bear put spread or a bear call spread. These spreads can offer you the opportunity of taking advantage of overpriced insurance in making your hedges more efficient (Ot080714.Pdf).

10-16-09 Buying Protective Puts - Figure 1