Does this make sense?

Question

I have a question regarding a trading strategy that I am interested in pursuing. The strategy is as follows:
BUY: 100 shares ABC @ 19.00
BUY: One Jan 19 Put contract for ABC
Premium- $1*100= $100
Profit: $20+
Loss: $18-20
Even: $18 or less
By hedging the purchase of 100 shares of ABC, the options contract acts to decrease risk but in doing so also limits my potential profit. Essentially, I would be betting that upon expiration, ABC would be priced anywhere but within the $18-20 range. The strategy operates best in highest volitility. Immediate volitility inflates an options premium which in turn expands the area of inprofitiblity having, consequentially, this would most likely only be a hedge against loss moreso than a profit yielding strategy. However, while past and immediate volitlity are priced into an options contract is that the same for forecasted volitlitiy such as an impending earnings report?

Answer 1

First off, I have no idea what your objective is behind this strategy. So you are entering into a Long Position @$19 and you are in a Long Put ABC Jan 19 contract, @ $1.
You are out $2000, (long position and long put premium). You would need to break even when ABC hits $20/share.

Now forcasted violatility is merely subjective. You cannot accurately forecast that, which is where risk comes into play. So the contract will not place earnings report risks into their price. Market demand will determine this, as other analysts/investors may know more than you and are either avoiding this contract, or seeking it out, for a specific reason.

Now you state: " Essentially, I would be betting that upon expiration, ABC would be priced anywhere but within the $18-20 range." If this is the case than this is not the strategy for you. Since you are anticipating an essentially stagnate market for this stock, you are paying a lot for that put contract. You would be better served to implement an income strategy.
Hold your long position, but sell a Put contract for those 100 shares of ABC you are currently holding long. Place the strike price at $19. The contract will expire out the money if the market drops to $18/share (as you anticipated) as well as it would be out the money anything over $19/share. Your long position was the insurance you needed on the Short Put contract, and the income you received from the premium is profit. Plus any gains you would receive from your long position assuming you kept it to the point it generated a return.

Hope this helped.

Answer 2

First, your profit analysis is wrong. If the stock is anywhere below $20 per share when the option expires you will have a loss.

The combination of a long stock position and a long put is a synthetic long call position. In this case, what you proposed is equivalent to buying a call with a $19 strike price for $1.00.

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It only limits your profit by the amount you paid for the put option. If the stock goes to $100 per share you will make $80 per share instead of the $81 per share you would have made if you had bought the stock and not bought the option.

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That is because you profit analysis is wrong.

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Higher implied volatility increases the price of the put option making the strategy less effective. You want to acquire long option positions when implied volatility is low.

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An increase in implied volatility inflates an option's premium. Frequently when a stock goes up implied volatility drops.

<<<... which in turn expands the area of inprofitiblity having, consequentially, this would most likely only be a hedge against loss moreso than a profit yielding strategy.>>>

Prior to expiration an increase in implied volatility increases the option premium which expands the area of profitability. At expiration implied volatility is no longer a factor in the value of the option.

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Historical volatility is not one of the variables used to determine an options price. The only volatility variable is implied volatility which is a market consensus of forecasted volatility. In determining implied volatility traders look at both historical volatility and scheduled events, including earnings reports.

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I suggest you review how protective puts work. There is a good write up at

http://www.cboe.com/Strategies/EquityOptions/ProtectivePuts/Part1.aspx

Answer 3

A person only should buy a put if he/she is fairly certain that the price will drop and for some reason can not sell the stock prior to that drop.The usual way to hedge a long position is to sell(short) the out of the money calls (mainly because most options expire worthless) that way if the stock falls you roll down the strike of the call (sell more calls) as it drops if the stock goes up you have the out of the money part to give you a gain if stock called plus the time and volitility premium.