Covered options are often adopted by conservative investors taking a “slow and steady” approach to the stock market. The real advantage with covered options is that you can boost the earnings in your underlying stock position via the premiums you receive from selling the options (assuming things go in your favor, of course). Naturally, however, these extra returns are finite and come with the risk of unlimited theoretical losses. Wouldn’t it be better to flip the tables, that is, to have limited losses and boundless potential gains? Introducing protective options.
Protective Puts
This method involves buying both the underlying stock and an at the money put option for that stock to protect against losses. Strictly speaking, it’s called a protective put if the put is purchased after the stock is already in the portfolio. But if the put and the stock are bought simultaneously, then we call it a married put. Here’s how it would work: say you buy a stock on its own at $40. In that scenario, you have nothing protecting downside risk, nor anything impeding hypothetical returns.
Pretty straightforward: as the stock price falls below the purchased price ($40), losses begin to incur and as the stock price rises above the purchased price, profits are made. But if your portfolio were to consist solely of puts, the payoff diagram would look something like this:
The maximum theoretical loss from a long put option is fixed, as are the maximum theoretical gains since puts become more in the value the further the underlying stock price declines (and stock prices can’t drop below 0). A protective put is simply the combination of these 2 positions, represented by the following payoff diagram:
The blue and green lines represent the long stock and the long put positions, respectively, whereas the red is the protective put strategy. The profit potential is unlimited since you’re still holding a long stock position (stock prices can, theoretically, just continue rising), but the earnings will be offset by the premiums you pay for the put options. That’s why the stock price must rise above $42 for the red line (protective put) to yield profits, but only $40 for the blue line (long stock).
Additionally, the losses for protective puts are capped at whatever the put premiums were. Remember, a put option gives you the right, but not the obligation to sell the underlying asset at the strike price. Hence, even if your long stock portfolio declines in value, all you have to do is exercise your puts and pocket the difference — puts become in the money when the stock price drops below the strike price. So if the stock were to decline to $30, the long put gains ($40 - $30 = $10) would cancel out the long stock losses ($30 - $40 = -$10), leaving the only losses the put premiums of $3. The worst case scenario would be if the puts expire at the money, as that would mean you can’t exercise puts and end up losing whatever you paid in premiums.
It’s no coincidence that the protective put payoff diagram is identical to the long call payoff diagram. Fundamentally, both strategies bet on the stock price rising, with the main difference being that protective put investors are more concerned with and seek protection against short-term uncertainties in the stock price.
Protective Calls
Similar to how covered calls contrast with covered puts (outlined in our previous article), protective calls are sort of the flip side of protective puts. Rather than a long stock position, investors short the underlying stock like so:
Again, a straightforward concept. The higher the stock price rises, the more your short position will lose value and vice versa. Of course, shorting a stock is far riskier than buying it since there’s no downside limit; stock prices can, theoretically, just continue rising. The second component to the protective call strategy is a long call option:
Here, the losses are limited to the premiums paid for the call, and the profits (that is, the difference between the strike price, in this case $40, and the stock price when you choose to exercise the call) are limitless. And yes, as mentioned previously, this diagram matches that of the protective put’s. Now combining these positions:
The blue line is the short position, green line the long call, and red the protective call. Just by looking at this graph, some of you may already be drawing parallels between the protective puts and calls. If the stock price is below the strike price ($40), the call option is out of the money and expires worthless, thus losing you the premiums you paid for them. But the short position will have profited, and so your total profits would amount to the initial stock price ($38) - call premium - the stock price when you exercise it. Profit-wise, the only difference between a protective put and shorting a stock is that the former’s gains will be offset by the call premiums.
In fact, just like protective puts, the most you can lose with protective calls are those option premiums. Say the stock price rises above the short price of $40 to $50; although the short position will suffer a $10 loss, exercising the call option will yield $10 ($50 - $40 = $10). The remaining expenses are the option premiums.
It may involve a long call option (which will become more in the money the further the stock price rises), the protective call is bearish as it ultimately benefits from a decrease in underlying price. Investors may want the protective call when they expect the underlying price to decline in value, but seek the upside protection that’s simply unavailable with directly shorting stocks.
Protective options are an excellent illustration of the balance between risk and reward in finance. In both put and call scenarios, investors are sacrificing potential gains for insurance against things not going their way. It all boils down to hedging one’s bets, and comparing one’s fear for safety with their desire for profits.
Econ IRL
Cryptocurrency needs no introduction. Its volatility, technological innovations, and security concerns all contribute to its endless media coverage. In this week’s paper, the researchers studied the impact of market sentiment on crypto returns. Unlike other assets, cryptocurrencies do not have an underlying cash flow to determine their valuation and so market sentiment plays a crucial role in traders’ decisions.
Their findings illustrate that social media sentiments can reliably predict crypto returns, unlike sentiments from news media. While certain sentiments are caused by crypto-specific fundamental events (changes in transaction speeds, technological improvements, security breaches, and regulatory developments), some are purely market exuberance, which fundamental events cannot explain. Interestingly, it is the excess market emotions, which are independent of fundamental events, that best predict crypto returns. The hypothesized cause is that market exuberance affects price perception and stimulates speculative demand (demand driven by an expectation of future price appreciation), which influences future returns.
‘Till next time,
SoBasically