At time of writing we’ve just had a massive run up on the market and your share positions are probably looking a lot healthier, at least for now. What happens though, if the markets take another dive? Why not look at protecting your shares with Put options.
Puts are an extremely versatile hedging tool. They give the buyer the right, but not the obligation, to sell the underlying share at a specified strike or exercise price. Essentially you are buying an insurance policy for your shares.
Let’s look at NAB, down over 30% in 2 months, from a high of $30.79 on the 24/07/08, to a low of $18.60 on the 18/09/08 and now opening at $25.45 on the 22/09/08.
Chart 1 – NAB in ProfitSource software
click to enlarge
As you can see from the chart, NAB is still in a Wave 5 down and the fifth wave is yet to be confirmed as being completed. I personally would like to see a strong close above $26 before I accepted that the share had stopped dropping.
In this trade I’m buying 1000 NAB shares at $25 per share and then buying the NAB October 08, $24 Put options for $1.40 or $1400 per contract (1000 shares x $1.40). That means I have the right to sell my NAB shares at $24 regardless of how far they may fall. As you can see I will be paying for this right, but with all the uncertainty at present I need to weigh up the risk of doing nothing, compared to the cost of buying the Puts.
At least now, if NAB does fall substantially again, I’m guaranteed to net $22.60 per share, that is, I’ll receive $24 for the shares less the premium of $1.40 that I paid for the Put options. Obviously not the perfect scenario, but at least I now know what my maximum risk is. This gives me almost 6 weeks of protection on my shares. Should the market continue to rise, I can always sell my Put options and recover some of the cost of the premium should my view change.
Chart 2: NAB risk graph of 1000 shares in OptionGear $24, Put contract
click to enlarge
As you can see the maximum loss on the trade is now $2600 and the upside break even is $26.40.
Another thing I could do if NAB did continue to rise, would be to sell a Call option contract against the shares, this would help pay for the cost of the Put options.
However, I wouldn’t sell less than the $28 October Call options. This would then guarantee me a reasonable profit should NAB rise above $28 and I had to deliver the shares. This particular strategy of buying shares and a protective Put option and then selling a Covered Call is known as a Collar trade.
Remember, you always have options,