Investing Like A Pro

Day Traders and Swing Traders and Options? Maybe!

Typical day traders and swing traders look for stocks with quick,short term movements, and are not in the business of holdingpositions overnight let alone a week or two. So the use ofoptions has not usually been a component of their tradingstrategies.

Now however, some new opportunities for profit are availablesince many day trading firms are allowing their traders to tradeoptions. Unfortunately, many option strategies do not apply tothe quick in and out nature of day trading. Neither day tradersnor swing traders are typically in a single stock long enough forthe strategy of selling options for premium collection to beviable.

Since these traders often look for break-outs, and sometimes gobottom fishing to find opportunities for profit, a premium payingoption might work well for them. Why? Because the trader wouldbe buying protection from catastrophic losses. Bottom fishingand breakouts are associated with volatility, which meansuncertainty and risk. However, there is a strategy that willprovide the necessary protection for these traders to carrypositions through overnight risk, while remaining fullyprotected. This would still allow also them to take advantage ofthe large potential upswing that was the original goal ofidentifying the bottom and the break-out. This strategy iscalled the protective put.

THE PROTECTIVE PUT

The Protective Put Strategy involves the purchase of put optionsin combination with the purchase of stock and works well insituations where a stock is prone to rapid, volatile movements.

A put option gives an owner the right, but not the obligation, tosell a certain stock, at a certain price, by a specified date. For this right, the owner pays a premium. The buyer, whoreceives the premium, is obligated to take delivery of the stockshould the owner wish to sell at the strike price by thespecified date. A strategically used put option offersprotection against substantial loss.

The protective put strategy is a strategy that is ideal for atrader who wants full hedging coverage. This strategy is veryeffective in stocks that normally trade under high volatility, orin stocks that normally do not trade under such high volatilitybut may be involved in an event driven, highly volatilesituation.

When an investor purchases a stock, they can buy the put(protective put) to provide a proper hedge. The construction ofthis position is actually quite simple. You buy the stock andyou buy the put in a one to one ratio meaning one put for everyone hundred shares. Remember, one option contract is worth 100shares. So, if you buy 400 shares of IBM then you need topurchase exactly four puts.

From a premium standpoint, you must keep in mind that bypurchasing an option, you are paying out money as opposed tocollecting money. This means that your position must"outperform" the amount of money that you paid for the put. Ifyou were to pay $1.00 for a put and you owned stock against it,the stock would have to increase in price $1.00 just to breakeven. The protective put strategy has time premium workingagainst it, thus the stock needs to move to a greater degree, andmore quickly, to offset the cost of the put.

When we buy a stock, three potential outcomes exist. The stockcan go up, go down or it can remain stagnant. If we were toanalyze the three scenarios, we would find that only onescenario, the up scenario, can produce a positive return andthat's only when the stock increases more than the amount youpaid for the puts. The other scenarios produce losses. If thestock is stagnant, you lose the amount you paid for the put. Ifthe stock goes down, you lose again- but the loss is limited. Itis the limiting of loss in highly volatile situations that makesthe protective put an attractive and useful strategy.

This is how it works! Imagine you buy stock for $31.00 and buythe 30 strike put for $1.00. If the stock goes down, theposition will produce a loss. For example, if the stock is downto $30.00 (down $1.00) at expiration of the option, you have a$1.00 capital loss. With the stock at $30.00, the 30 strike putswill be worthless, thus you incur a $1.00 loss because that iswhat you paid for the put. Your total loss will be $2.00. Usingthe protective put strategy set a cap on your losses. The putstrategy's attractiveness is that it will allow you to set losslimits!

Let's see how that works. We'll set the stock price down to$28.00. Since you purchased the stock at $31.00, there will be acapital loss of $3.00. The puts, however, are now in the moneywith the stock below $30.00. With the stock at $28.00, the 30strike puts are worth $2.00. You paid $1.00 for them so you havea $1.00 profit in the puts. Combine the put profit ($1.00) withthe capital loss ($3.00) and you have an overall loss of $2.00. The $2.00 loss is the maximum you can lose no matter how low thestock goes because the buyer of your put must take the stock atthe strike price. This is the protection the put provides.

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