Put options for portfolio insurance ~ the married put

The long put option is similar to the long call option in that the
investor has the right but not the obligation to exercise. The purchaser of a
put option has the right to sell the underlying at the strike price on or before the expiration date in the case of an American style option or on the expiration
date if the investor owns a European style option. The owner of a put will
participate in the downside of the market with risk limited to the premium or
price paid for the put contract. Puts can be purchased to profit from a price
decline in a stock, an index or a commodity. For example if you own an all
stock portfolio with 20 holdings and are concerned about a general price
decline in the market, you could purchase a put on a broad based index that
would increase in value if the market declines. The tactical option investor who
purchases a put that is not used to hedge a portfolio against a market decline
is considering a couple of different factors. The first is an analysis of the
underlying to determine if it is overpriced or not. There are a variety of
fundamental research sources that can be used to help determine if a stock or
an index may be overvalued. Once we have determined some overvalued investments to consider, then we study the charts and consider the momentum of the investment. An individual stock or a commodity for example may seem to be overvalued but its price momentum can continue upwards for long periods of time and they can become even more overvalued. The application of some technical analysis can find investments that are overvalued and have some downward price momentum. A moving average crossover can be a good simple tool to apply. The third step is to indentify underpriced put options. You can find an overvalued stock in a downtrend and if you pay too much for the option it may not produce a profit. To locate undervalued options you need to consider the historical volatility of the stock, the implied volatility of the option and study the history of the implied volatility to see where the implied volatility is relative to its long term averages. The difference between a speculator and a
tactical option investor in these types of transactions is that the tactical
option investor will have a fundamental opinion on the underlying investment,
apply some technical analysis to see if the price momentum is favorable and
find a reasonably priced option. The tactical option investor will also buy an
option with sufficient time remaining in the contract for the price movement to
develop. Many option speculators experience failure because they don’t take the time to properly analyze these three steps and they trade in too short of a
time frame. There is much work to be done when taking directional trades with
options, the markets are very efficient and arbitrage opportunities rarely
exist.  Using a long put to hedge a portfoliois different because the investor chooses the option contract based on hisunderlying portfolio and is concerned about portfolio protection or insurance. Puts used for portfolio insurance are known as protective puts. Married puts are put options that are tied to a certain number of shares of a specific stock.

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About sellacalloption

Author, Radio Show Host and Portfolio manager and chief option strategist for IWC Asset Management.

Posted on September 13, 2011, in Options for portfolio protection and tagged , , . Bookmark the permalink. Leave a comment.

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