Wednesday, July 28, 2010

Don't Be Afraid of Options - Part 4: Buying Puts as (Expensive) Insurance

Let's face it...nobody likes accidents, not car accidents nor accidents in his/her investments.  For the former, we all have liability insurance to protect us against lawsuits and comprehensive insurance to protect us against losses due to accidents or theft.  For stocks, there is a way of buying insurance and that's by buying put options for that the same stock of which you hold shares.

As you recall, by buying a put option, you have the right to sell a certain stock at a certain price before a certain date.  So, if your stock dips below the strike price of your put option, the option becomes in-the-money and you can exercise your option.  By doing so, you can sell your shares at the higher strike price, thus, limiting your loss.  This all sounds good until you find out what the premiums are for this insurance.

Hefty Insurance Premiums
For my car (I just bought a 2006 Toyota Prius for $14650 CAD), I'm paying about $120/month of insurance.  A majority of that cost is in liability insurance.  A small portion is for comprehensive (the portion that actually covers my car).  I don't know the exact breakdown, but I believe it's something like 80-20 split.  So, effectively, I'm paying about $300/year to insurance against the cost of my car.  That is about 2.0% of the cost of my car for 1-year's worth of insurance.

Now, let's look at the cost of buying a put option to insure against your investment.  Um...let's look at Apple today (Ticker: AAPL).  The price of AAPL shares are $262.55 at the time of writing.  Let's say you had 100 shares of AAPL and were really worried about that iPhone 4 antenna.  So, you decide to buy 1 contract of a put option at strike price of $260 that expires in August 2010.  That will set you back a cool $6.00/share as it is currently priced.  Notice that this option is out-of-money because the strike price is $2.55 below the current share price.  If the stock falls below $260 before the 3rd Friday of August, you can exercise the option and be able to sell your shares for $260.  But how much is the premium that you are paying?  That's easy enough to calculate...$6.00 (price of option) divided by $262.55 share price = 2.3%.  So, you are paying a premium of 2.3% per month to insure your investment!

Things get a little better if you opt for the longer term.  If you decide to buy the same option that expires in January 2012, the price is $46.69/share.  That works out to be $2.60/month or 1.0%/month.  It all sounds good except when you really look at the implications.  Since you paid $46.69/share for that put option, you are down $46.69/share right away...poof...gone!  Before anything even happens, you're down 17.7%!  In fact, for you to break even, AAPL needs to rise to about $309.

So, why would anyone buy a put option for insurance purposes?  Actually...yeah, why?  If I wanted to hold AAPL until August, what I could do is simply this: buy AAPL at $262.55.  If it drops by $8.55 ($6.00 cost of option + $2.55 since the strike price is at $260), which is exactly how much it would have cost me to buy a put option with strike price of $260, I would sell the shares and say, "OK, that's enough for me."  That would have the same effect as buying the put option.  If instead of dropping, it rose in price, I don't have that $6 premium weighing down on me; I start making money the moment it rises above $262.55.  One caveat is that if the price drops a huge amount overnight (i.e. more than $8.55), then your loss would be greater because the next morning, you would have to sell at the lower share price.

In theory, buying a put option as an insurance policy is a very prudent move.  However, in reality, put options cost so much that they outweigh any benefits that they provide.  I do not recommend using this strategy unless for some reason, the put option is priced very cheaply.  Plus, if you have done your homework and know exactly how much your stock is worth, then when the price goes down, you would actually want to buy more to accumulate the stock!  That, however, is the topic of another post!  For you Canadians, have a good long weekend!