Here is another analysis. I’m buying the $19 put, which gives me a total risk of $430, until the 3rd Friday in July, in which this option expires. If I were to purchase another option – let’s say I went to the $20 put option at this. Now, my downside risk is only $200.
Of course, my upside potential is greatly reduced. However, I only have $200 of risk, in an $18,000 purchase. If I went even higher, now my risk is only $160. Again, my upside potential is also extremely limited.
Where you buy your put is up to you. Whatever you feel comfortable with. I feel comfortable with a $400 loss on a stock. I’ll explain to you another reason why I feel comfortable with that.
On an $18,000 purchase, if I lost $430, I would be okay. It would not bother me. Here is where it gets really interesting. In order to demonstrate exactly what I’m talking about here, we have to go back to the Think Back page, for just a second.
The Think Back analysis tool in Think or Swim allows you to take a look at what option prices sold for, in a time at the past. Let’s take a look at the Starbucks chart again here. Let’s say you were one of those enthusiastic people who purchased Starbucks stocks back here, for $40, on November 16, 2006.
Tell me the truth. If you saw only this part of the chart, what would you think about this stock? You would think, “Hey, this thing is going up. This could be going up for quite some time.”
Let’s go back to November 16, 2006, in our Think Back tab. Let’s call up the Starbucks symbol, and change the date to November 16, 2006. At that time, we had the November options, which only had 1 day left. We had the December options, which had 29 days left.
Let’s take a look at the December options, because it still had 29 days left. At that time, if you were to purchase Starbucks stock at $39.43, you could have purchased the $37.50 strike price options, the put options, for 90 cents. 1000 shares would have cost you $39,000. The insurance would have cost you 90 cents a contract times 10, which would have been times 100. That is the multiplier, which would have cost you $900.
We’ll just go up to 10 contracts. At that time, the $37.50 would have cost you $900. That would have provided you with some protection, at least. You would still have lost the difference between the strike price and the price of the stock, which was $39.43, minus $37.50. Your maximum risk on this trade would have been approximately $2500.
That was probably not an acceptable risk to me. It may have been, to you. I probably would have purchased the $40 put, which was a little bit more expensive, at $1.90. That would have cost me $1,900 in order to protect that stock. However, that stock cost me $40,000. $1,900 of insurance would have been a little bit more expensive.
However, let’s see what would have happened, the very next day. Remember, I’m buying this option here. They put the mid-price in here, which I may have been able to get, for $1.85.
Let’s see what happens in the very next day. The market opened, and the $40 options that we purchased for $1.85, are now worth $2.90. If we take a look back here again, the stock opened up down here, at $37.
If we continued, you would have seen the stock continue to decline, until it hit $35, just a few days later. Remember, we purchased the stock here, at $39.43, which was at the close. By December 1, it would have been trading at close to $35.25.
Let’s see what would have happened to our $40 put, on December 1. Our $40 put would have risen in price, to $4.90. Actually, we could have sold it for $4.80. Remember that on the 16th, we purchased the option for $1.85.
We fast-forward to December 1. It was worth $4.80. That’s approximately a $3 difference. How much did we lose in the stock? The stock went from $39.43, down to $37.30. That’s about a $4000 loss.
However, we gained a little bit – almost $3000 – in the price of our put option. We bought the December $40 puts. That would have given us $3000 of protection, on the downside of a stock that just dropped $4000. We still would have had on the stock, but we would have gained $3000 in the put option.
Let’s say we bought the $37.50 put, which was cheaper, at $85 cents. Would that $37.50 put option – we could have sold it for $2.30. That’s a difference of only $1.50. We would have had $15 in protection on the downside, on a stock that dropped $4000.
The idea is to select the strike price on the put side for protection, as insurance on your position, in which you feel comfortable. My goal, when I’m purchasing stock initially – this is on my opening position. If I was to purchase this stock at $40, I would want to have the stock prove itself and limit my initial risk to less than $500, generally.
Let’s do the opposite. Let’s say that we actually decided to purchase the stock. Let’s go back to our current positions, and let’s say, like I did – I purchased the stock right around $16. This was on May 13.