Published by Robert W. Huntley, CFP®, CHFC®, CKA® Founder & Wealth Advisor
Imagine you’re a farmer nearing the harvest of your annual corn crop. Everything you have is riding on this crop and you must get at least $3.80 per bushel or you’re in trouble.
You want to lock in the price, so you don’t end up with a disaster on your hands. You turn to the future’s market and pay a hefty premium to guarantee yourself you’ll get at least the $3.80 per bushel price. If the price ends up higher than that, you’ll be out the cost of the future’s contract. You’re still willing to pay for it because the downside is just too much if prices collapse at the wrong time.
This is basically what a “put” option is in the stock market. It’s a contract guaranteeing you the right to sell a security for a specific price over a certain time frame.
Let’s look at an example:
Suppose you inherit some stock from your grandmother and it’s currently worth enough to completely cover the upcoming cost of your daughter’s four-year (you hope) college education. Today the stock is worth $100,000 if you sold it all.
However, you don’t want to sell it because you like the company, and it’s trading at $100 per share but expected to go up over the next few years. Plus, it’s paying a nice 3% dividend and that income could also help offset some of the college costs.
On the other hand, you remember how rotten you felt in 2008 when the market was in full on meltdown mode. What if something like that happens again? Ugh.
It’s just not worth the risk of a meltdown, but you still don’t want to sell the shares yet. What can you do?
You can consider purchasing a “put” option on your shares. Suppose you want to ensure your worst-case scenario? If the stock is selling today at $100 per share and you have 1,000 shares, then you can buy a “put” option on 1,000 shares of the company stock to lock in that $100 per share price for the next 2-4 years.
A “put” option costs you what’s referred to as a “premium” for buying the right to sell your 1,000 shares of stock at today’s $100/share price over the next few years.
Let’s say hypothetically in our example it would cost you $5,000 today to guarantee you the right to sell your 1,000 shares for $100 per share over the next two years. You figure out that the dividend on the shares will more than cover that cost, so you think that’s a good trade-off.
You hate to spend the dividends on the “put” option but if the stock price falls a lot, you can still sell it to the person you bought the “put” from and they’re obligated to give you $100/share on 1,000 shares regardless of how low the price has fallen. At least your downside is protected.
Also, if the price per share goes up like you think it will, you’ll just look at the cost of the “put” option as the price of protecting your downside.
You’ve locked in your worst-case scenario. In a way, it’s sort of like buying homeowner insurance on our house in case it burns down. Most of the time the house doesn’t burn down, and we pay our insurance premium for nothing. However, when you have a fire, the insurance saves you big time.
Option prices vary a lot depending on the security, length of time, and current market volatility. They are traded daily and so long as you’re trading in well-known companies, you’re likely to have plenty of liquidity for your desired objective.
You just need to weigh the costs of the “put” versus your concerns about market volatility. In our college expense example, it’s important you don’t have a big short-term loss. So, it would be worth carefully analyzing the costs of a “put” option on that stock to make sure you don’t get hit while your daughter is still in school.
Our firm routinely uses this sort of strategy in various ways to manage portfolio risks. Put options are a simple idea really, but like anything, there is a layer of complexity and some level of artistic license involved in using options to hedge portfolio risk. Hopefully, this simple explanation takes away some of the mystery for you.
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Examples provided are hypothetical only, and do not represent the actual performance of any particular investments. Options may not be suitable for all investors