You've sat through yet another day watching your
run another 20 points or fall another 18.
While it's just a day in the life of the individual investor,
2000, the down days have you a little worried. You decide it's time to buy some protection. The typical approach to this would be to buy put options, which increase in value as the price of a stock decreases. They also give you the right but not the obligation to sell the stock at the strike price by the options' expiration date.
'Cept for one thing: one glance at the prices for these particular options and you've got a bad case of sticker shock. Even if you want to protect yourself from a 20% drop in JDS Uniphase (while it's at 118), the April 95 put option will cost you 4 5/8 ($462.50). If you're holding 500 shares of the thing, the register will ring until it hits $2,312.50 for the purchase of five April 95 put contracts.
But considering that you're buying an option that's 20% away from having an ounce of intrinsic value, you're paying for a very real chance that JDS Uniphase can drop right through that strike price at any time, the same way it could blow through the strike price of a call that's also 20% out of the money.
Remember, an option's price is made up of intrinsic value, time premium and volatility. When a put that's so far out of the money is trading for only five bucks, make the leap that there's a whole heap of volatility in the thing. That's what will cost you dearly.
Despite the high prices, Michael Schwartz, options strategist at
CIBC World Markets
, says he has been encouraging his clients to buy deep out-of-the-money puts as "disaster insurance" on some of their more volatile holdings.
"You can go 50, 60 or 100 points out of the money on some of these stocks if you bought them at a low price," he says. "It allows you to stay long and avoid a taxable event."
If you're lucky enough to own one of the
highfliers that's appreciated 500% since you bought it six months ago when it began to rally, selling the stock now could subject you to a major capital gains headache. Buying the put lets you stay long because you can make some money as the stock falls and feel comfortable enough to stick with it.
Price sensitive or otherwise, John Power of the
Chicago Board Options Exchange
says investors have one simple question to answer before they begin to plot strategy: "What scares me most?"
Sometimes, it's best to sell calls, he says, and take in some premium. But that caps your upside, something you may not want to do with a stock that's liable to run 45 points in one day.
If you sell, for instance, a JDS Uniphase call at 180, when the stock hits 200, you'll be forced to sell it for 180 unless you buy the calls back at an inflated price.
If the answer to the fear question is the annihilation of the stock price, then no put could be too expensive. "Buying a put may be expensive, but it gives you complete coverage."