Case Study – Put Options

For a starting options trader I recommend reading this chapters on Investopedia. It explains the
basics of options trading and give you a good understanding of how options work and how they can
benefit your investment portfolio.

http://www.investopedia.com/university/options/

Below I’m going to explain a strategy which you can use when investing ‘long’-only. This means your
portfolio consists of bought shares and you are not doing any short-selling.

Let’s say we have $5000 in cash that is ready to be invested. In order to protect our order with a put
option, and thereby limiting our risk. We need to buy at least 100 shares of the company or a
multiple of 100. We also need to save cash to buy the insurance (put-option).

Stock: EWH – Ishares MSCI HongKong Index Fund

This is actually an ETF, that’s a fund that is traded as a company stock. The advantage is that you can
invest pretty cheaply into one country and the volatility of the options is often lower, which is
necessary in this strategy. Volatility increases the price of options, and you want to buy your
insurance as cheap as possible of course. Therefore it is important for you to buy a stock with low
volatility on its options.

Volatility on the DEC 2010 options: 22% (Below 25% is best, Above 40% is too expensive)

Above you see the chart of the last 9 months of this stock. January till the end of May was up and
down and from there it had a powerful rally. A correction is not unlikely here, and is something that
can occur at anytime. So it is smart to protect our investment with a put option.

Author: Martijn Reek (DHCO Benelux) Copyright ©26-10-2010

Stock Price (26 Oct. 2010): 18.94

The price per share allows us to buy 200 shares of the HongKong ETF.

Total Price for 200 shares: 200 x 18.94 = $3788

An affordable risk is about 2-3%, so we don’t want to pay more than $75 - $115 for 2 put-options.
The price of 1 option would then be 0.37 – 0.58 (75 / 200)

We want to buy the DEC 2010 puts, from today there are 52 days left, we could have bought the NOV
2010 puts, but that is a little short-term. The DEC puts give us more time for the stock to move.

The DEC puts that suits our risk analysis are the puts with a strike price of 19. So that is a little out-of-
the-money, but the closest to the price we bought the shares for. It’s price is 0.60 per option.

Total price for 2 DEC 2010 19 PUT = $120 (0.60 x 200)

Because the options are six cents below the option strike price, we can decrease our total risk by $12
(0.06 x 200)

Total risk in this trade: $108 = 2.9%

Our trade has been setup, we leave the trade for a couple of weeks now.

Now we are going to look at the power of this strategy. Let’s assume that in the coming weeks there
will be a correction of about 10%. The share price decreases to $17. In our trading platform
(ThinkOrSwim) we can analyze what the price of the options will be 5 weeks later (23 Nov. 2010)

Price per share: $17

Total value of shares: $3400 (17 x 200)
Price of DEC 2010 19 PUT: 2.03

Profit on shares: (18.94 – 17) x 200 = -$388

Profit on options: $286.67
Total profit: -$101.33

Because we limited our risk with a put-option, our loss just exceeded $100. Now we can decide to
sell our put-options and use this money to buy a new one at a lower strike price (17) and use the
other part of the profits to accumulate new shares.

Because the share price is lower now, we can get cheaper insurance than before. Last time it cost us
$120, let’s say it will be around $105 now. (not the real price) Then we have $182 left to buy new
shares. In this case we can buy 10 shares in this ETF. The only disadvantage is that these shares
cannot be insured, you need 100 new shares for that. So it is definitely better to start out with more
cash or find a stock with a lower price.

If shares continue their rally from last couple of months we will make a profit, we will lose the money
we put in the insurance, but we made a small profit with limited risk. There is no need to worry
about the stock price.

Author: Martijn Reek (DHCO Benelux) Copyright ©26-10-2010

So in this strategy we make money on the way up and accumulate more shares on the way down. So
we have more shares to profit from when stocks rally back.
It can be frustrating though if you pick a stock that starts a multi-month decline, this will add up small
losses and it takes more time for the stock to reach the levels where it is bought.

In all cases you have to do your own research first, so that you are confident in the future
performance of the stock. The stock used in this article is NOT a recommendation, it is just used as an
example for this strategy.

Good Luck!

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Author: Martijn Reek (DHCO Benelux) Copyright ©26-10-2010