by Russ Allen, Online Trading Academy Instructor
Online Trading Academy Article of the Week
In Part One and Part Two of this series, we described the use of put options to protect the value of a portfolio of stocks, ETFs or mutual funds. Today I want to tie up a few final considerations on this topic.
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In a very small nutshell, the example we used was buying a put as protection for a position of 100 shares of SPY, when SPY was trading at around $289 per share. Our goal was to limit our loss to no more than 10% of the value of SPY, over a 6-month period of time. We used a put at the $265 strike price that expired six months out in March 2019. The puts at that time could be bought for $4.91 per share in lots of 100 shares each, that is $491 for each put.
If the worst came to the worst and SPY dropped below $265, then the put option would empower you to turn over the 100 SPY shares, together with the put, to your broker and receive $265 per share in cash. This would be true even if SPY dropped much further than $265, even to zero. So, your worst-case outcome would be a loss of $24 per share on the SPY position (current price of $289 less the guaranteed price of $265); adding in the $4.91 cost of the put, your total loss of value would be $28.91 per share. This was almost exactly 10% of SPY’s $289 value.
If SPY did not drop but instead went up, then your potential profit on the SPY shares would still be unlimited. However, your profit in that case would be less by $4.91 per share than it would otherwise have been (due to the cost of the put). You would think about this the same way you would think about paying for insurance on your car, just without claims. Was the insurance premium wasted because you did not crash your car? There are two legitimately correct answers to this: a) yes it was wasted but I had no way of knowing that ahead of time, or b) no it was not wasted because I did enjoy the protection even though it turned out not to be needed. Which way you look at it depends on whether you are a keg-half-full or a keg-half-empty kind of person.
In any case, the ownership of the put absolutely prevented you from experiencing a loss of more than a known maximum amount.
Now, in earlier articles we talked about using SPY puts to protect not SPY itself, but a portfolio of different stocks, mutual funds and/or ETFs. If I owned a put on SPY but did not actually own SPY, then how would the protection work? I would not have the SPY shares to be surrendered with the put to get my $265.
In that case, the way the put would work as protection is that the value of the put would go up if the price of SPY went down. SPY’s price would be expected to drop by an amount roughly equal to the drop in the value of your portfolio, divided by your portfolio’s beta (discussed in part 2). You would offset the loss on your assets eventually by selling the SPY puts at a profit rather than by exercising them. One way or another, you would sell the SPY puts on or before their expiration day. Once the SPY puts were sold, you would have to decide whether to replace them or to forgo further protection. If everything now looked rosy in the markets, you might decide not to replace them at that time.
Finally, a few words about possible tax consequences of using puts as protection. The following would not apply if you used SPY puts to protect non-SPY assets. It would apply if you were using puts on a particular stock or ETF to protect that same stock or ETF.
First, as you are no doubt aware, when you sell a stock, your profit or loss is considered a capital gain or capital loss. If the asset was held for more than a year, it is considered a long-term capital gain/loss; otherwise a short-term capital gain/loss. Long-term capital gains are taxed at lower rates than your ordinary income tax rate. Short-term gains, however, are taxed at your full ordinary income tax rates. So, the holding period (amount of time you held the asset) matters.
If you buy shares of a stock or ETF, and at the same time you buy a protective put on that same stock, for tax purposes this is considered a married put. When you eventually sell the stock, your holding period for the stock is not affected by having the put.
However, if you already own a stock and at some later time you buy a put on that same stock as protection, then it is called a protective put, not a married put. If you buy a protective put and you have not already held the stock for over a year, then your holding period on the stock starts over when you buy the put. This is how that could hurt: You have owned 100 shares of stock for 11 months. It cost you $50 per share and is now worth $100 per share. You now buy a protective put at the $90 strike. Another nine months later the stock goes down to $80. You then exercise your put, surrendering the stock and receiving $90 per share. You have a gain on the stock of $90 less your original cost of $50, or $40 per share. It is now 20 months since you bought the stock; but since you bought the protective put just nine months ago, you are deemed to have a holding period of only nine months, not 20 months. You do not qualify for long-term capital gains treatment and will be taxed at your full ordinary income tax rate on the $4,000 gain.
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