The ROle of Puts in Enhancing a Conservative Portfolio

I am a very simplistic kind of investor, but I know enough to know when I’m being belittled.

I take lots of offense at the diminutive status that is so often assigned to the individual investor. Even something so simple as to refer to the first hour of trading as “amateur hour,” or to the prevailing belief that the individual investor is best served by stepping aside and letting the big boys play with stocks, leaving ETFs and mutual funds to the “amateurs.”

The problem with that kind of advice is that it assigns the individual investor to being a perennial victim of circumstance and events. It removes the ability to be proactive and have a role in one’s own financial destiny.

There are many tools that are used to offer protection. The vast majority are far more complex than I have either the patience or the aptitude to understand or implement.

But the truth is that the basic tools that are necessary really are just basic and are well suited even to those that like a simple approach to balancing risk and reward.

That would be me. You might be far more complex in your desires, but for me vanilla works.

I’ve very much altered my acceptance of the use of puts in advancing the goals of my portfolio over the past few years as I’ve practiced a predominant covered option strategy. The first step that an investor has to take is to get over the fear of the bottom falling out from underneath a stock. Besides, you should get rid of fear and all other emotions anyway when it comes to your portfolio.

My predominant use of puts has been to sell them when shares in companies that I’ve followed and have liked had taken very large price drops. Sometimes those drops were related to earnings, sometimes the drops were in sympathy with sector related news and sometimes they were irrational reactions to macroeconomic news or rumors.

The unifying threads were that the drops were sudden, large and in otherwise solid companies. The use of Puts was not meant to be speculative. In such cases the sale of puts may be undertaken when there is reasonable evidence to suggest that a price rebound is likely and will occur in the near term.

Puts are also a nice tool for exploiting price movements in volatile stocks when a known event, such as earnings is on the horizon. The problem with earnings related use of puts or covered calls is that you may have to spend more time than you want looking through historical charts to see how an individual stock has behaved in the past under the same circumstances.

Who has that kind of time or patience? Besides, it is by its nature a risk related trade, albeit the use of puts is a relatively conservative way to establish a vested interest.

But the lowly and isolated put can be a great adjunct to a covered call strategy, especially for the investor that wants some additional protection and is willing to offset some option premium in exchange for greater piece of mind and greater responsiveness to unexpected price drops.

When comparing the pros and cons it is very much an issue of comparing tangible to intangible characteristics.

The tangible aspects in this case are all negative factors. For starters, utilizing the Split Option Strategy involves three opening transactions, rather than just two. You purchase shares, sell calls and sell puts.

In addition to the tangible costs associated with the additional transaction, there are potential opportunity costs in that the purchase of fewer shares will result in less dividend income derived from Double Dip Dividend trades.

Finally, the strategy calls for the use of out of the money puts which would be expected to provide smaller option premiums than near the money or in the money call options., especially during periods of low volatility. During periods of high volatility or a strong bullish trend, the technique typically uses out of the money puts and calls so that the premium differential is extinguished.

The positive aspects of the strategy are to offer greater downside protection to portfolios and increased comfort during transient price drops, as well as providing the means to take advantage of decreasing share value.

For those that have been following the OTP strategy for a while, you know that one of the techniques frequently utilized is the “Having a Child to Save a Life” approach. That is a strategy that seeks to ease paper losses from a position by purchasing lower priced shares and selling calls solely on the lesser priced shares in an attempt to optimize premiums to offset the paper losses and encourage assignment of new shares quickly.

That strategy is very successful at providing relief during a drop in share price that makes it unappealing to sell call options on shares at a strike level that adequately provides profits.

However, the problem with the technique is that you may not have the funds readily available to make those purchases just when the opportunity is presented.

Instead, selling lower priced puts at the time of the initial stock purchase is a statement of confidence in your shares. If you loved shares enough at $40 to make the purchase, surely you would love it even more at $38. The benefit is that while you may never have to commit to the $38 shares, you get a premium while the clock is ticking.

If share price does go down and you are assigned, you have just had the “Having a Child to Save a Life Strategy” executed for you and now it is time to seek an appropriate strike price at which to sell calls.

If not assigned the cash becomes available for redeployment as warranted´╗┐ upon expiration. As opposed to the cash that gets freed up following assignment of shares, the funds from expired puts are considered as “settled” and can be used for very quick round trip transactions wi
thout incurring “Free-riding violations” from your brokerage.

A typical Buy/STO Trading Alert may look like this:

  • Buy XYZ Corp (XYZ). STO $32 Apr 12, 2013 Calls and/or STO $30 Apr 12, 2013 Puts. Current price $32.01. Premium call $0.35 bid. Premium put $0.24 bid. TRADITIONAL. Rating UU


Ultimately, the “Split Option Strategy” (SOS) provides comparable income streams while being more defensive than the straightforward covered call strategy.

Coordinating and executing three different trades at the prices you seek can be a challlenge. Individuals should decide whether the Split Option Strategy is more consistent with their investing temperament and tolerance for risk.


Don’t forget to read about the AC/DC Strategy