For the majority of market participants, the recent new highs are as much a time for concern as they are for celebration. Two emotions exist: Fear and greed. Do I stay long shares of stock and make more money (greed), but risk giving back a major portion of the profits should I participate in a long overdue correction (fear)?
For newer option traders you have a few tricks up your sleeve that stock traders don’t. Married puts and collars do a decent job of providing protection, but at a huge cost (in risk, capital and/or profit potential).
An example of a married at-the-money put is: Take a stock such as Apple Computers, Inc. (AAPL), which closed on April 3, 2013, at $431.99. The ATM 430 strike put will cost you $21.35, or $2,135 per put contract. This equates to 4.9% of the share price. Similarly, the married out-of-the-money put, called a “disaster put,” can be used to hedge a position. For example, suppose to avoid the high cost of ATM insurance, a trader opts to buy a 400 strike put that closed at $9.20. It does cut the price of the insurance down by more than half, but now the put does not kick in to protect the position (on expiration) until the stock falls below $400. With this position the stock can drop down to a $390.08 break-even price (400 strike – $9.20 put cost) before the put does any favors. This, too, is unacceptable by most traders’ standards.
A better solution is the “platinum hedge,” which is a strategically created put butterfly position that is used to hedge a long stock (or index, commodity, etc.) position. It is constructed in a way that takes the underlying’s probable range into consideration, yet offers close to the same protection (if done correctly) as a married put at a fraction of the cost. An example:
1) Long 100 shares of AAPL at $431.99
2) Long 1 contract 430 – 375 – 320 put butterfly ($21.35, $4.10, $0.52)
Because we are buying an ATM 430 strike put when purchasing the butterfly hedge, any drop in the price of the underlying below $430 causes the butterfly to pick up intrinsic value immediately. This will offset the loss on the declining share value. Had we simply bought the 430 put naked as a hedge, it would have been a $21.35 investment, but the butterfly costs just a tad over half of that when trading for $13.67 (see “Long stock & long butterfly”).
This is not a “world is coming to an end” play. Rather, it is a fairly easy to accomplish position (if set up correctly) that will do a superior job of hedging positions over the long run when compared to almost any other strategy.
Also, those who like collars can sell the May 450 call at $13.30 to offset the cost of the butterfly, just like collar traders sell a call to offset the price of the naked put (see “Long stock, long butterfly & short call”).
When constructed correctly, the platinum hedge can offer the same amount of protection as a married ATM put while providing all the benefits and cost savings of a far OTM put hedge. Combine this with a short call to pay for the position, and you have something dreams are made of. Goodbye fear — hello greed!