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Repositioning Using Puts

Jason Ayres
December 3, 2013
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6 minutes read
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One of the challenges with the current market is that stocks have been extending gains on a month over month basis with very few pull backs. This is great if you had the foresight to position yourself early. However, the probability of a correction increases everyday that the market pushes higher, diminishing the near-term upside potential. This makes jumping into the markets a less than attractive proposition from a risk/reward perspective. Many investors are now feeling the pain and humiliation from sitting on the sidelines. The question at hand is…do I get in now and weather a much needed correction (for the record, I am not suggesting a crash) or do I continue to stand on the sidelines and miss a continuation. Truly a “damned if you do, damned if you don’t” scenario.

This emotional conflict is well personified in Benjamin Graham’s allegory on Mr. Market, where he suggests “Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is”. Truly a dilemma.

How do you take a decisive stance on a stock that is overbought and benefit from a continuation higher in share price while hedging for a potential correction? The answer is a simple protective put.

Often times, investors familiar with the options market will look at a protective put as a way out of a stock in case a good investment goes bad. While that is one way that a put can be used, we also have to recognize that stocks don’t trade higher in a straight line. If the expectation is that a stock will trend higher over a longer time horizon, the put can be used to reposition at a lower price. This will reduce the average cost of the shares as well as the breakeven point.

Let’s consider an investor that has missed the move in Canadian banks. While the sector is strong, it is not immune to the natural ebb and flow of the markets. Recently, Toronto Dominion Bank (TSX:TD) has topped $98.00/share and has pulled back to just shy of $97.00. Now, this should not necessarily cause panic in current share holders, but it may cause aspiring investors to re-consider buying at these levels. After all, large corrections always start off small.

An investor may wish to purchase 100 shares of Toronto Dominion Bank(TSX:TD) at the current price of $96.85. This would require a capital outlay of $9,685.00. To hedge against a possible near term correction a January put at the 96 strike may be purchased for $1.75/share, or $175.00.

This immediately brings the average cost basis of the position to $98.60 as the cost of the put option is added to the average cost of the shares. However, the investor now has a maximum risk of $2.60/share from now until the expiration date of the option. The risk is calculated by adding the cost of the put to the difference between the share purchase price and the strike price.

Let’s assume that the shares drop down to $92.00 over the next month.

If the shares were trading down at $92.00 on expiration, the investor could exercise their right to sell the shares at $96.00. This would be bring in $9,600.00. The investor could then repurchase 104 shares at $92.00. Admittedly, the additional 4 shares doesn’t lower the average cost by much, but it will certainly help the recovery process. While the investor would not be able to purchase a protective put to hedge those 4 shares without being “over hedged” due to the 100 share multiplier, the additional dividend payments picked up will add to the bottom line.

If we consider the new average price of $92.00, the cost of the previous put and additional risk on the shares must still be accounted for. By adding $2.60 to $92.00 we arrive at the adjusted break even price of $94.60. As a result, the investor has continued to own Toronto Dominion Bank through a pull back, adjusting the break even on the shares to a lower and more easily attained level. The put protected investor would start to profit a little lower than $94.60 due to the additional 4 shares, needing only a $2.60 move. The unprotected investor that simply bought the shares and decided to wait it out would would need a $4.86 move just to break even.

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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