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Let’s go to May 13, 2008. The options that we had available were the June options. I purchased – the stock was trading at $15.95, at the time. I bought it for $16. I purchased a slightly in the money put option, at $16.
In other words, I felt that the downside risks of the potential in the stock were pretty low. However, I didn’t buy a lower strike price. I bought the put option as insurance, at the same price as the stock.
In other words, if my stock went down – if I bought it at $16, and I bought the $16 put, if it went down to $15, I would have gotten paid $1000. That put option would have been worth $1000, minus what I paid for it. I only would have lost the 68 cents that I would have purchased it for, or approximately the $680.
Do you see why that is the case? If the stock falls 1, I lose $1000 on the shares of the stock. I gain 42 cents, because that $16 put will now be worth $1, if the stock drops to $15. I made a $420 profit on that. However, I paid 68 cents for it, so that is my maximum risk. My maximum risk was $680 on the stock. Even if it fell to $14, I still would have had a maximum loss of $680 on the stock.
Now, as we advance, the price of the put option declined. However, the price of the stock increased. Now, my $17 puts are only worth 75 cents. I lost $400. Because I paid 68 cents for these, I lost approximately $650 on this particular option. However, since I purchased the stock at $16, I made $1000 on the price of the shares of the stock.
I made money. I let the stock prove itself. In other words, when I opened the position, I wanted as much protection as I possibly could get. As the stock advanced in price, my option – the $16 put – declined dramatically.
However, I made $2333 on the stock. Because my $16 put option now is only worth 5 cents, if I wanted to sell it, I lost approximately $630 on the put option, my insurance.
At this point, since the price of the stock is farther above my strike price here, I still have a $2 potential loss, or $2000 potential loss in the stock, if the stock went back to $16. Since I lost approximately $630 in the put option, and I have a $2333 profit in the stock, that still leaves me with about $1800 in profit.
I took some of the $1800 in profit to purchase additional protection. I still have these 10 $16 put options. However, at the time, I also purchased another 5 of these $18 put options as additional insurance, which cost me an additional $200.
That $200 came out of my profits. Not only did I lose 63 cents here, but I purchased another insurance policy at a higher strike price, for an additional $200. That’s $800 in cost for my insurance. I still have a profit of approximately $1500 on increase in the shares of the Starbucks stock.
As we get closer to expiration, what I would do, is if the stock continued to increase in price, I would roll over the put options that I have available here. I would roll them into the next month’s strike price, into the next month’s options. Put options as insurance. Depending on where the stock is, I would either go a little bit lower, because remember, now I have some built-in profit. I have approximately $2333 in built-in profit at this time.
I don’t need as much protection now, because I do have a cushion of profit in the stock. I have 10 of these $16 put options. I could sell those, and purchase an additional 10 of these $16 put options for 17 cents. It would cost me an additional $120. However, I also have additional protection, because now I’m 50 days out in protection.
I could also purchase 10 of the $17.50 strike price options, which would give me even more additional protection on the downside risk of my stock. At that point, it’s almost like I have locked in the profits, minus about a dollar. As the price of the stock goes up, I can also continue to roll up my protection underneath that, to lock in the profits that I have.
After the stock has proven itself – it’s up $2.33 from where I purchased it – I would not be so inclined to purchase an in the money put option in order to limit my downside risk, at this point. I would certainly roll up the strike prices in my puts to be a little bit closer to the money.
For example, a $17.50 put would be a much more attractive option to me, because of the lower cost. I would not do that initially, because my potential exposure to a brand-new downside position is much larger. I would want the stock to have a lower risk on the initial position. If it did decline on me, I would have a maximum loss of only $440.
The stock has proven itself and moved up, so now I can roll up my strike prices. I also don’t have to go as deep in the money. I can go at the $17.50 level, and still have enough protection at a lower cost, as the stock continued to increase.
As the stock increased, let’s say we go out to October. If the stock was at a decent level – if it was about $25, or it continued to rise in price, I would continue to roll up my put options, each and every month that I held this position.
You might be asking yourself, “Why would you continue to purchase insurance on the stock, if it has gone from $16 to $25? You have a fairly large profit in the stock already. Why would you continue to roll up your puts?”
Because I do not use stop losses. Here’s the reason why.
Let’s go back to our Starbucks stock again. Let’s say you purchased Starbucks stock right here. On this particular day, you could have easily purchased it between $17.70 and $17.85. If you purchased the stock at that point, and you said, “Okay, do you know what I’m going to do? I’m going to set a stop loss on the stock. I’m going to have it held with my brokerage company. I want it to be sold at the low of this previous bar, which was $17.40.”
You set a stop loss, and you had absolutely no other type of protection. You didn’t have any of the put options that we were discussing.
To your surprise, the very next day, the stock opens at approximately $16. Your stop loss order was transferred to a market order, and your stock was sold. Rather than at the price you determined would be your stop loss, $17.40, it was actually sold at $16, at the opening price of the stock.
Your stop loss was triggered. It turned into a market order. Now you’ve sold out your entire position at $16, $1.40 lower than you had anticipated.