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Does anyone buy Puts to reduce risk?
Old 03-17-2009, 06:56 PM   #1
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Does anyone buy Puts to reduce risk?

I dont' recall any recent discussions involving the use of Puts to establish a floor on your portfolio. I understand that you can buy them on ETFs.

Is anyone on the board using them? My understanding is quite limited, but wanted to hear any real-life accounts that are out there.


Here are two articles on the subject
The basics: http://stocks.about.com/od/advancedt...onBa022705.htm
The equity collar: http://blogs.money.aol.ca/2008/04/21...tion-strategy/
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Old 03-17-2009, 09:36 PM   #2
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Yes, I purchased put options on the S&P in the latter part of 2008. This was quite profitable for me.
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Old 03-17-2009, 09:58 PM   #3
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The best way to set a floor on your portfolio is to allocate more to cash.

Cash pays (a little). Puts cost money. Why do you think someone (like me) tries to sell them to you?

I have bought puts on a few occasions. One was for a stock I wanted to hold into the next tax year. Another was to hold through an earnings announcement, but I didn't want to sell and miss a run up either.

Why are you attracted to them?

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Old 03-18-2009, 10:30 AM   #4
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Puts are an insurance policy. The difference between the current stock price and the strike price is the "deductible". For this you you pay a premium. Like all insurance, the bigger the deductible, the lower the premium. The advantage of buying puts vs holding cash, is that 100% of the upside (less the premium) is preserved, and the floor is well-defined. Holding cash reduces your risk, but the floor is the cash allocation (the stock could go to zero). To have a "reasonable" floor, one would have to hold so much cash that the upside would be severely limited.

The disadvantage of buying puts today is that, because of the high volatility in the market, put premiums are very high.
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Old 03-18-2009, 10:33 AM   #5
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No, but under certain circumstances it could make sense. Let's say that you have an equity position that you want to liquidate -- but can't for at least a few months. Your primary concern is that the stock (or the market) will tank before you can sell the equity position for whatever legal reason. Buying a put would effectively protect you from catastrophic market crash (or if that stock becomes GM or AIG or C).

The problem with buying puts today -- as mentioned above -- is that in a volatile and fearful market puts are very costly.
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Old 03-18-2009, 10:38 AM   #6
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If you want downside protection today, but don't want to pay the high put premium, one strategy is to create a "collar" by selling an out-of-the-money call to pay part of the put premium. This will cap your return, but will lower the insurance cost.
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Old 03-18-2009, 11:16 AM   #7
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It seems to me that over a length of time measured in years, puts are going to remove most of your potential upside.

Puts make sense if you want to limit downside over a short period of time (ERD50's tax example is reasonable).

Puts don't make sense for a long-term investor though. The premiums are very likely to cost more than your upside over the long-term. I think you're better off just selling the stock if you are afraid of the downside.

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The disadvantage of buying puts today is that, because of the high volatility in the market, put premiums are very high.
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Old 03-18-2009, 11:25 AM   #8
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Puts don't make sense for a long-term investor though. The premiums are very likely to cost more than your upside over the long-term. I think you're better off just selling the stock if you are afraid of the downside.
Provided you can. Perhaps you're in a 401K where your company match is in company stock... and you can't exchange it for another investment while you're employed there.

You may be planning to leave in (say) six months, at which time you can roll over into an IRA and trade out your company stock for something else. But until then, you want to guard against the company going Enron and busting your retirement. Seems like buying some puts for a long enough duration until you can divest of company stock could work. But again, in THIS volatile environment, the cost of that protection is pretty steep, perhaps as much as 10% of the value of the underlying stock.
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Old 03-18-2009, 12:13 PM   #9
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It seems to me that over a length of time measured in years, puts are going to remove most of your potential upside.

Puts don't make sense for a long-term investor though. The premiums are very likely to cost more than your upside over the long-term. I think you're better off just selling the stock if you are afraid of the downside.
Certainly the expected return of a put-protected stock is lower that that of one that is not put-protected, even in a time of more normal put premiums. However, it doesn't follow that you will remove most of your upside potential, only some of it. And this is to be expected, since you are reducing your risk.

But your suggestion that one just sell the stock and go to cash also cuts into the long-term return if your timing on when to buy back the stock isn't correct. The beauty of a put is that it makes this market timing decision for you automatically, and it is never wrong.
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Old 03-18-2009, 03:28 PM   #10
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You're very likely to pay more in puts than you expect the stock to return.

Take MSFT. If I wanted to protect myself until Jan10 (about 10 months), I would need to buy either the Jan10 15 or 17.5 puts, since the stock is at about 17. The 15's cost 1.89, and the 17.5's cost 3.24. So it will cost you somewhere above 11% of your investment to use puts to protect yourself for 10 months.

That doesn't seem cost effective for the long-term, given that 11% is a pretty good return for a stock. If the stock goes up 11% by January, you break even. If it goes down, you lose 11%. If the stock goes up dramatically, you still have that upside, but over the long-term these premiums will eat you alive.

Going to cash cuts into your upside as well, but you have no downside, and you aren't paying 11% per year for insurance.

Using puts for protection is fine for the short term if you can't sell the stock, but it is very expensive as a long-term hedge.

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Certainly the expected return of a put-protected stock is lower that that of one that is not put-protected, even in a time of more normal put premiums. However, it doesn't follow that you will remove most of your upside potential, only some of it. And this is to be expected, since you are reducing your risk.

But your suggestion that one just sell the stock and go to cash also cuts into the long-term return if your timing on when to buy back the stock isn't correct. The beauty of a put is that it makes this market timing decision for you automatically, and it is never wrong.
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Old 03-18-2009, 03:59 PM   #11
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I think the important thing to understand about puts is that prices of puts has sky rocketed over the last 6 months. Similar to how the price of Hurricane insurance shot up rapidly right after Katrina and her sisters pounded the Gulf coast a few years ago.

One measure of the price of puts (and calls) is the volatility index (VIX) or so called fear index. A couple of years ago the VIX was between 10-15. Last fall the index spiked upward into the 40-50 range and even went as high as 90 at time. What this means is the cost of puts/portfolio insurance has increase by roughly three to four times.

By way of analogy imagine you spend $1,000 for collision insurance on your expensive late model car, after a decade of no accidents you suddenly have 3 within the space of a couple months. After the 3rd one your insurance company raises your rates to $4,000 (of which $3,000 is for collision coverage). Now you can continue to pay $4,000 a year for several years, or you can elect to skip collision insurance and instead resolve that you'll put the money you aren't spending in insurance in an automobile replacement fund.
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Old 03-18-2009, 04:09 PM   #12
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I think the important thing to understand about puts is that prices of puts has sky rocketed over the last 6 months. Similar to how the price of Hurricane insurance shot up rapidly right after Katrina and her sisters pounded the Gulf coast a few years ago.
Yep. When people are at their most fearful, the price they will pay for security ramps up dramatically.
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Old 03-18-2009, 04:32 PM   #13
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You're very likely to pay more in puts than you expect the stock to return.
This is simply incorrect. If it were true no one would be buying options at these prices.

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Take MSFT. If I wanted to protect myself until Jan10 (about 10 months), I would need to buy either the Jan10 15 or 17.5 puts, since the stock is at about 17. The 15's cost 1.89, and the 17.5's cost 3.24. So it will cost you somewhere above 11% of your investment to use puts to protect yourself for 10 months.

That doesn't seem cost effective for the long-term, given that 11% is a pretty good return for a stock. If the stock goes up 11% by January, you break even. If it goes down, you lose 11%. If the stock goes up dramatically, you still have that upside, but over the long-term these premiums will eat you alive.

Going to cash cuts into your upside as well, but you have no downside, and you aren't paying 11% per year for insurance.

Using puts for protection is fine for the short term if you can't sell the stock, but it is very expensive as a long-term hedge.
The price of MSFT has ranged from 15 to 32 over the past 52 weeks, and MSFT is not a particularly volatile stock, relatively speaking.. Someone who paid 11% for a one-year put on MSFT when it was at 32 would feel pretty good right about now. Or, if he paid 11% today, and MSFT went back to 30 in the next year, I don't think he'd be complaining. Option premiums are high now, but look at the market volatility. Many of the bank stocks have doubled in the past 2 weeks. People were paying 10% for one-month calls on WFC two weeks ago when the stock was at 8. It closed at 17 today.

BTW, an at-the-money put has a hedge ratio of about 0.5. So if you own the stock protected by a put, you are starting with the equivalent of a 50/50 stock/cash position. If you do the math, you will find that the expected return on the stock/put position is higher than that of a 50/50 stock/cash mix, if you assume the implied volatility of the put is a good estimate of the future volatility of the stock.
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Old 03-18-2009, 06:02 PM   #14
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Well, I'm not very well versed in that game either.. but I did put my toe in the water in 02' and then my foot last yr..
I bought Some Inverse Funds at Pro funds in International ( UXPIX) for a short term basis and it worked out very well..

now been buying the other way with Bull Funds > Small cap UAPIX on the Bottom of the S&P and Russel 2000 to accelerate Recovery $..
but stricly as a short term investment..

another way I did a Recovery play in 02' for the future was taking $ out of my conservative Funds and putting it into my aggressive equity funds for yrs 03' and 04', then sold that off and put it back into my conservative Funds..Picking up an extra +18% vs doing nothing and leaving things alone, after the same timeframe.


i think with the invention of these ETF's, Leveraged options, etc? will make things alot different going forward in the Investing world for Future Inwestors and they best learn as much about them as they can.. It's a nice way for Mutual Fund Owners to either insure or take advantage of Bulls and Bear runs..

of course it is Timing and Trading which many MF investors Don't like to do, but May not have much of a choice going forward anymore..
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Old 03-18-2009, 09:10 PM   #15
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Why are you attracted to them?

-ERD50
All, thanks for the great discussion.

ERD50, I was interested in them to protect against a possible downward move in the markets like the one we just experienced in the last 6 months. Like many of us, I saw the black clouds accumulating, but having been convinced that you can't time the market, I just sat there like a deer in the headlights and watched it take a big chunk of my savings. I see this as insurance, but obviously have a lot to learn of the cost.

I want to learn about it for use in the future. This discussion has opened my eyes to the complexity (cost of the insurance). I have much to learn before I try it.
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Old 03-19-2009, 01:21 PM   #16
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Tell that to the people who go to casinos.

Options are a negative-sum game. Spreads and transaction costs guarrentee that, as a group, people buying and selling options will lose money.

Yes, if the stock moves a lot the put strategy is fine. How about when the stock moves up 11% in a year and you end up with zero return? How about when it drops 5%, and you end up with a -11% return?

Honestly, who do you think is going to be further ahead in 20 years, the person who buys puts each year for 11% of their portfolio's value, or the person who takes that 11% each year and buys a CD to hold along with his stocks?

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This is simply incorrect. If it were true no one would be buying options at these prices.



The price of MSFT has ranged from 15 to 32 over the past 52 weeks, and MSFT is not a particularly volatile stock, relatively speaking.. Someone who paid 11% for a one-year put on MSFT when it was at 32 would feel pretty good right about now. Or, if he paid 11% today, and MSFT went back to 30 in the next year, I don't think he'd be complaining. Option premiums are high now, but look at the market volatility. Many of the bank stocks have doubled in the past 2 weeks. People were paying 10% for one-month calls on WFC two weeks ago when the stock was at 8. It closed at 17 today.

BTW, an at-the-money put has a hedge ratio of about 0.5. So if you own the stock protected by a put, you are starting with the equivalent of a 50/50 stock/cash position. If you do the math, you will find that the expected return on the stock/put position is higher than that of a 50/50 stock/cash mix, if you assume the implied volatility of the put is a good estimate of the future volatility of the stock.
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Old 03-19-2009, 01:22 PM   #17
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Puts seem too expensive to use on a regular basis, but I could see using them:

- For short term "buying time" uses (e.g. have to hold something for tax reasons but really want to sell it for position reasons).

- If a worse-than-historical event happened and I needed time to digest whether unwinding my current position made sense.

I think they are most useful for people trading on insider information (or thinking their information is that solid). Therefore I have not much use for them.
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Old 03-19-2009, 01:51 PM   #18
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Let's use the whole market for another example.

SPY is about 80. You can buy a Dec09 put for about 10.75. So 9 months of protection costs you 13%.

You own puts and the underlying stock. At the end of the year, if the market has gone down, you have lost 13%. If the market goes up 13%, you break even. And if the market goes up 50% you make 37%.

The only time you do better with the puts is when the market drops more than 13%, and it is only a big help if it drops substancially more than 13%.

Making bets every year that the market will go down more than 13% is not a great longterm strategy, IMO.

Even during the last major drop, the returns were only -9.1,-11.9,-22.1 for 2000, 2001, and 2002. So holding the index through that drop would have left you with 100*.909*.88.1*.779= 62.4% of your money left after the decline.

Buying the puts would have left you with= 100*.87*.87*.87= 65.9% of your money.

Not exactly the great insurance I'm looking for.

Granted, puts are very expensive right now, because the volitilaty has been very high recently. There may be times when this makes sense to use, but in general, I think its a bad bet.

You're probably better off buying one of those indexed annuities

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Tell that to the people who go to casinos.

Options are a negative-sum game. Spreads and transaction costs guarrentee that, as a group, people buying and selling options will lose money.

Yes, if the stock moves a lot the put strategy is fine. How about when the stock moves up 11% in a year and you end up with zero return? How about when it drops 5%, and you end up with a -11% return?

Honestly, who do you think is going to be further ahead in 20 years, the person who buys puts each year for 11% of their portfolio's value, or the person who takes that 11% each year and buys a CD to hold along with his stocks?
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Old 03-19-2009, 05:49 PM   #19
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Excellent example Hamlet. I was going to use exactly the same analysis with Dec 80 puts on the S&P 500. Options are a negative sum game (although my transaction costs for options average about 1-2% so it isn't huge drag on performance and professionals costs are even lower)

I think there can be a case for the use of options for people in or near retirement, but primarily as a writer of options. Especially covered calls as way of reducing the volatility of portfolio performance. In this bear market I have taken advantage of the fear premium priced into put options, and written many puts on companies that I wanted to own (Wells Fargo, GE, Apple) at lower prices. Obviously in many cases I regretted writing these puts when the stock dropped well below the put price. There maybe even a time to be purchaser of options especially for tax reasons. Although I won't do so other than in stock specific condition or when the VIX index drops into the teens again.

If you are concerned about future drops in the market, I think the simplest and probably lowest cost solution, is to reduce your asset allocation to a level which you are comfortable.

Of course my caveat is that having all of your money in safe investments (T Bills, CDs) makes it very hard to save enough for retirement or sustain an existing one.
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Old 03-19-2009, 11:00 PM   #20
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The problem with Hamlet's example is that he is comparing portfolios of different risk levels. To do a fair comparison, one should compare the put-protected index to one of the same risk, i.e. a stock/cash portfolio, and it should be done over a statistical ensemble of stock returns. The risk-equivalent stock/cash portfolio will have a cash position roughly equal to the put's initial hedge ratio (I say roughly because you must buy the put out your initial funds reducing the amount of $ you have to buy stock).

To make the comparison fair, one should assume that the put is fairly-priced, i.e. the implied volatility is a perfect predictor of the future stock volatility. Then assume an expected return for the stock (index), and calculate the expected returns of both portfolios. Alternatively, one could use a Monte Carlo simulation, with the mean equal to the expected stock return (continously-compounded) and the standard deviation equal to the put implied volatility.

I claim that, if you do this correctly, you will find that the expected return for the put-protected stock will be slightly higher than that of the risk-equivalent stock-cash portfolio. Intuitively, the reason for this is that as the stock rises, the put hedge ratio drops, raising your stock allocation more quickly than the stock/cash portoflio, and vice-versa. In effect, the put acts as a very good market timing mechanism (it would be perfect if it were free).
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