Friday, March 05, 2010

Deciding Upon Protection

In the last couple of articles, I wrote a little about issues of risk. Risk seems to be one of those things that too many traders consider only after they find themselves facing already existing losses. Too often, that seems to be the same time that greed may dissipate and fear increases, sometimes to the point of near paralysis. As I have written many times and as I emphasize with my individual coaching students, the time to assess risk is before entering the trade, not as losses mount or after substantial losses have already been achieved.

One question that has arisen on the blog relating to the articles on risk is what is the "best" protection. Some believe a stop loss order does the job well enough and others contend that the way to go when owning stock is to buy protective puts. Each of those routes has advantages and disadvantages (as is true with so many things we do in the markets) and whatever the choice, there must necessarily be some compromise.

One may first consider that a given trader might chose to have no protection and simply buy a stock and take the whole risk that the position could go to zero. Though I don't know it is the case, I suspect that most individuals who buy stock take precisely that approach; they buy the stock and have no protection in place and, in fact, frequently have no exit strategy whatsoever. Clearly, that is one approach. Is it the best approach? Who can say. That is an individual decision and I have little qualms with it so long as the trader has an understanding that the whole investment is then always completely at risk. If that trader makes such a choice, he need only be prepared to live with it. Living with it is that persons decision and one only hopes that he is not kidding himself into believing that the stock can't take a precipitous drop, perhaps even to zero. We can all name instances of that exact occurrence.

More conservative traders might choose other alternatives to attempt to protect their investment. One such choice for the stock buyer would be to buy protective puts. In those situations, the trader pays a premium and buys a put which enables him to assign his stock to someone else at a specific price anytime before the put contract expires. In that sense, it is akin to an insurance policy. For example, I might buy shares of XYZ at $20.50 a share and also buy the $20 puts. In that case, let's suppose the puts I buy expire in 6 months and they cost me $1 a share. Now, until expiration, I can force someone to buy the shares at $20 so even if the stock dropped to $5 a share before expiration, I could still get $20 a share and therefore lose only 50 cents a share on the stock, but, of course, the premium for the put cost $1 so I would actually be down $1.50 plus commissions. Still way better than losing $15.50 a share on the stock, but in order to achieve a profit in that 6 months, the stock would have to be above $21.50 a share at option expiration.

Another alternative discussed in the blog is the stop loss order. If we take the same example of XYZ above, we might place a stop loss at $19.95. That means if the stock falls to $19.95 or below our position is automatically sold at the then market price. Suppose it dropped to $19.90 and our stop was hit and the position sold at $19.90. There we would have limited our loss to 60 cents total. The problem, of course, is that stocks can gap down and in those situations the stop loss only offers a partial protection. Suppose we had the same scenario with a stop loss at $19.95 and on Thursday the stock closed at $21 a share, but that evening after the market closed XYZ released some bad news. What happens on Friday? Presumably, the stock is down significantly at the open. For our example, let's say the stock opened at $17.50 on Friday. Well, our $19.95 stop has been hit, but there is no one there to buy at $19.95 or even close so our stock is sold at $17.50 and we suffer a $3 a share loss. The really good news is we are out of the position and will not suffer additional losses from a continuing drop. We have cut our loss (and could get back in if it turned back up). The bad news is we didn't get out near the $19.95 we expected.

These examples are meant to be just that -- examples showing a couple of ways a trader may attempt to protect a position and cut losses. Is one better than the other? For each of us, the answer is probably "yes," but for subjective reasons which we choose will differ. Stops may be preferable to buying puts because it costs nothing to place a stop loss order but one does have to pay a premium to buy a put and the put will expire. On the other hand, buying puts may be preferable because I don't run the risk of a gap down with the attendant larger than expected loss that could occur with the use of a stop loss.

Truth is, we can argue until the cows come home which is better, but the bottom line is that what is better for me might not be better for you and your goals, your time limitations, your risk tolerance, your position size, your trading knowledge and other assorted variables.

I can only suggest that it might be wise to figure out ahead of time whether you want any protection and, if so, what protection best serves the furtherance of your own personal trading plan. In fact, the first step is to create that plan that is specific to you, your goals, your needs, and your abilities. Plan creation and the elements I suggest be included as a minimum are set out in detail in my book, "Trade Your Way to Wealth".

Incidentally, for those who use TeleChart and/or StockFinder software, I've been invited to and will do a free webinar on March 16th for Worden Brothers, the publisher of those services.

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved

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To comment on Bill's article click on the "comments" link below.


~ Nona said...

As I think about your detailed comments re: protective puts compared to stop losses, I'm beginning to understand the issue differently.

It strikes me that one can buy very cheap insurance indeed by buying very far out protective puts. Am I also right in assuming that I would have to wait until expiration to exercise the puts if my stock's price fell sharply, even drastically? Obviously, I've never bought a protective put -- and I can definitely look back and say "I wish I had".

There are so many countervailing views re: this market. Maybe one should buy quality, dividend-paying stocks with (renewable) "insurance"!

Again, thank you very much for this post. It opened up my thinking re: protective puts versus stops. I value -- and needed -- that deeper understanding.

~ Nona said...

Never mind!

I just re-read your post and learned that by using protective puts, one can assign a stock any time before expiration.

Hmmmm..... I'm liking this protective puts insurance idea even more!


Bill Kraft, said...

Thanks for writing, Nona. When you have purchased protective puts, you can exercise them at any time until expiration. However, many traders would sell the put rather than exercise it when there is time left since the premium they would get would include any in the money value plus time value. Selling the put enables the trader to get the time value in addition to the intrinsic value and they can sell the stock at the same time they sell the put. Hope that helps.
Bill Kraft

~ Nona said...

I can sell the put WITHOUT selling the stock, right? (I understand now that I can exercise it at any time.)

If so, it seems to me that I can keep buying low-cost insurance inasmuch farther out puts are at lower prices. Similarly, if the price of the stock increases, then I can buy higher strike puts -- and far out ones, at that.

Again, THANK YOU for the education!!

Bill Kraft, said...

Right, Nona, the put can be sold without selling the stock. However, if a stock is falling and you sell the put you might well make a nice profit on the put but you still own a falling stock so if the stock is still heading down, a trader might want to get rid of both the profitable put and the losing stock at the same time. On the other hand, if the stock has turned back up, selling the put to take that profit and keeping the stock for any run up might be the choice.
Bill Kraft

Anonymous said...

Bill … excellent article … perhaps in a future newsletter you may want to mention the use of a “collar” trade to protect long positions at a very low cost … for me, this strategy works best for stocks that I expect to move up only moderately while protecting against a sudden drop …