This blog post was originally published on RealMoney on Oct. 12 at 12:01 p.m. ET. It's being republished as a bonus for readers. For more information about subscribing to RealMoney, please click here .

I have a few quick comments on an excellent and timely column by Adam Olienis on using put options to protect profits on stocks, especially those that have gone parabolic such as the Chinese market as represented by the iShares FTSE/Xinhua China 25 Index Fund ( FXI). Adam's suggestion to buy at-the-money puts against long stock, also known as a married put, is certainly one of the simplest and most effective forms of protecting profits.

The Cost of Protection

But it does come at a relatively high cost. In his example of buying the November $195 put for about $10.50 contract when the FXI is trading at $200 a share seemingly translates into a 5.25% premium for only six weeks of insurance.

And remember, an at-the-money option has a delta of 0.50, meaning if you want to be fully hedged from the get-go you'd need to buy two puts for every 100 shares you own. That jacks up the cost to more than 10%, or nearly 55% on an annualized basis.

Of course, an options delta increases as it moves deeper into-the-money. In this case the delta will approach -1.0 (note that a put's delta is often expressed as a negative number) if the FXI drops below $165 share. At that price, the $195 put fully hedges 100 shares no matter how much more the stock falls. But if a decline beyond 20% doesn't worry you, here is a alternative approach for establishing similar downside protection at a reduced cost.

Spread Instead

Instead of buying puts outright, consider using a vertical spread. A vertical spread is the simultaneous purchase and sale of two separate options that have the same expiration but different strike prices.

Sticking with the FXI when it was trading $200 a share, one could buy the November $200 put for $12 a contract and sell the November $160 put for $4 a contract. That's a net debit of $8 for the spread. If the FXI does decline to $155, the spread will be worth $40, or a $32 profit -- the width between strikes minus the cost of the spread (40 - 8 = 32). This compares favorably to owning the $195 put, which would also be worth $40, delivering a profit of $29.50, or 6% less on the same $40 decline.

And when I say "the same $40 decline," it should be noted the numbers profits on the spread are based on where the shares close on the Nov. 16 expiration. This highlights one of the main disadvantages of a spread vs. owning options outright: Due to the time premium embedded in the strike sold short, the spread's maximum profit cannot be realized until expiration or if it goes deep, and I mean really deep, into-the-money.

For example let's assume shares of the FXI are trading $160 on Nov. 1, the $195 put will be worth at least $35 a contract, the $200/$160 put spread will be trading around $33 due to the $7 of time premium remaining in the $160 put. Not a huge deal in this, especially considering the spread cost $2.50 less than the put, but it is something to be aware of and has greater implications the longer the time period until expiration date.

Control the Variables

The other item to be aware of that Adam mentioned is that if the shares suffer a sharp decline, implied volatility is likely to increase. A change in IV will have a greater impact on the price of a single strike position than the spread because the increase or decrease in the value of the option owned will be mostly offset by a similar change in the short leg of the spread. Implied volatility's effect on an option's price is referred to and defined by the Greek term vega.

But remember, vega can work both ways. A decline in IV can cause a dramatic drop in the price of an option. Spreads tend to mitigate the impact of vega. Anytime you can control one of the variables that affects the price behavior of an option position, especially one that is being used for hedging purposes, do so.
Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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