Buying protective puts on Exchange traded funds is an effective way of quantifying risk, an alternative to using stop loss orders and a method of repositioning yourself on long term holdings.
In order to buy a protective put you must physically own the shares of the underlying security for example ETF’s and you buy 1 put for every 100 shares you hold. You then pay to have the right to sell your shares at the specific strike price over a specific period of time.
In this example, we’ll apply this strategy to the fictional ABC Exchange Traded Fund. ETFs to Reduce Downside Volatility In this example the ABC is trading at $15.00 a share. Through your analysis, you are anticipating the market ABC stocks are in to perform very well over the next 4 months. Anticipating a potential rally as high as the $20.00 price range, our objective is to participate in the upside while managing the risk of the downside.
When we look at the 4 month $15.00 strike protective put, it is asking $1.50 a share. If we purchase 1000 shares of the ABC at $15.00 per share, it would cost us $15,000. We then purchase 10 puts to insure the downside risk of the investment.
This $1.50 per share represents an upfront 10% cost for the protection. But no matter where the ETF trades, you have the right to sell it at $15.00 a share over the next 4 months.
Let’s review the benefits of using protective puts over stop loss orders. The first risk of traditional stop loss orders is the risk of market volatility. In this example, you purchase shares in the ABC Exchange Traded Fund and just use a traditional stop loss order with no protective put and are whipped out of the market by your own stop loss order or every worst if you experience a morning gap slippage where the stock price had fallen overnight to below your stop gap and your actual order gets filled at a lesser amount than your stop loss.
With a protective put, there is no volatility stop out risk you have a guaranteed strike price exit with the only disadvantage being the upfront cost to purchase the cost of the insurance by way of the protective put.
In this next example we compare using the standard average down strategy with and without using options.
Traditionally investors by more shares at the lower market price to offset the higher price paid earlier and reduce the overall cost per share by averaging. Using protective puts as an alternative to traditional averaging down you would sell your shares at the put strike price and buy back your shares at the new lower price.
So when you buy protective puts it prevents that feeling of being trapped in a losing position and prevents you from turning a short term trade into a long term holding and tying up your cash and it also gives you control to reposition.
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