Being right even when you’re wrong…protecting your position with options

At Investable Wealth, LLC we strongly believe in protecting our equity positions with options.  A well researched position can fail for many reasons.  Stocks with excellent fundamentals and “proper” charts usually fail 30-40% of the time.  Add to that the threat of unforeseen news/events, a flash crash or just plain bad luck- no stock is immune from a dramatic price drop.

One method we use to help minimize losses is employing a “protective put” strategy.  Protective puts are sometimes referred to as “married puts” because both a stock and its put are purchased together.

The put’s value will move inversely to the stock’s…thus acting somewhat like a short term insurance policy for the equity.  If the stock increases enough to cover the premium of the put, then you’re in the money.  If not, your loss is limited to the cost of the put.

Here’s an example.  Let’s say that an investor was contemplating a position in gold following the Presidential election of 2012.  The investor is not concerned with a gloom & doom end-of-the-world scenario but is taking a prudent position (one taken by hedge luminaries like George Soros and John Paulson).  With the re-election of President Obama there are many concerns, including the implementation of Obamacare, Bush era tax cut expiration and the much overblown “fiscal cliff”.

Our investor in this example is forecasting uncertainty and turbulence in the market.  Rather than just wait things out in cash, he decides to invest in gold- anticipating at least a short term pop.  Gold has just broken through the 10 week moving average and he feels the technicals look favorable (see Chart 1) for at least a 12% upside.

IAU Protective Put EXAMPLE Chart1

He purchases IAU gold exchange traded fund (ETF) for a price in the mid to high $16’s and an April 20 $17 put for around a 3% premium.  Our investor is now able to sit back for the next 4.5 months anticipating his forecast of a 12% gain confident that a loss will not exceed 3%.

Over the ensuing months gold plunges more than 22% (see Chart 2).  The protective put limited the loss to about 3%.  Although the forecast was horribly wrong, the investor was still right (equity investments are not guaranteed, a prudent investor limits losses to 8%).

IAU Protective Put EXAMPLE Chart2

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