Married put

How do you pick the strike to protect your long stock? Do you always go cheap and just buy the front month OTM put so you won't lose an arm and a leg on the "insurance" in case the long stock moves in your favor?

 

I read an interesting post about this. Look for OTM puts with the highest volume and open interest. These probably cost less than $1.00. These puts are typically more volatile than ATM or ITM, so more bang for the buck. Also, theory behind the high vol/high OI is that you are in the company of professional traders, who are looking for portfolio insurance. Also, stick to the front-month.

 

Don't OTM puts have lower delta than ITM puts, i.e. they move less when the stock falls?

 

1) Lower delta---yes
2) Greater gamma and vega----yes
3) When the market declines, the OTM-puts become super-charged.

 

What if his stock stays put (does not move a cent), or worse moves down and the option expires worthless? My opinion is if one was to play with puts, the only sensible thing to do is to buy them for speculative reasons on individual stocks and go long puts. Other than that, index/etf options are the best to play in my view.

In addition (turkeyneck), why you do not just buy a call if you are long the stock and want to protect it with a put? It is more efficient from capital and commission point of views. Plus always hedge your call.

 

You don't get dividend with a long call. Or some "buy and hold" stock you don't want to sell for tax reasons.

 

You do receive it in the form of a discount on the call price.

 

Put protection is like an insurance policy. You have to determine how much protection you want. The more the protection, the costlier the policy. The lower the protection, the higher the deductible.

In option speak, the more OTM the put, the less costly the protection is but the more the stock can drop before the protection kicks in. The potential loss is the distance down to the strike plus the cost of the put.

Which strike and month to buy depends on how much you're willing to pay for the protection, how long you want it to be in force and how much downside you can tolerate.

If you're going to buy put protection, you need to be a bit successful on your stock picking otherwise you're going to be fighting a losing battle (some of your stocks will have to rise nicely to offset the cost of put buying).

A way to reduce or eliminate the cost of the put protection is to sell an OTM call against your stock, creating a collar. This is equivalent to a vertical spread so unless you own the stock prior to putting on the collar or you're going to trade the stock intraday against the collar, an initial position via the spread would be wiser (less slippage and commissions). The drawback back of the collar is that you cap the upside.

Essentially, you have to weigh your options

 

I doubt that this has much relevance for someone who is looking to hedge long stock.

 

The dividend is irrelevant. When all is said and done, the put protected stock holder who gets the dividend has the same result as the call buyer who collects interest on his principal.