know your options: IBM rolling over
Hi Mark

I bought a few thousand shares of IBM at 117. It is now trading at 115. Do I use puts or calls to protect my positions?

Thanks, Rose

Hi Rose,

The answer is 'either.' I prefer using calls, but take look at your alternatives:

If you want a lot of protection - if you want to be certain you don't get clobbered if the stock takes a big tumble, then you should buy puts. But this is very expensive proposition. You consider the expense as the cost of buying (expensive) insurance.

For example, you can pay approximately $340 (for each put - and that means 10 such puts per 1,000 shares) for the Oct 115 put. If you buy these puts, for the next 5 weeks you have the right to sell your IBM shares at 115, no matter how low the price goes. If you make this choice, then this is your bottom line:

  • Your net cost per shares increases from 117 to 120.40.  If the puts expire worthless, your insurance expires with it and you would have to buy more puts to have more insurance.
  • Your maximum loss, for the next  5 weeks, is $540 per share (if IBM is below the 115 strike price when Oct expiration arrives) because you would sell your shares at 115.

If you are willing to settle for less protection, if you want a better chance to earn a profit, and if you are willing accept only partial protection (and that means getting clobbered if the stock declines by a large amount), then selling calls is the right approach.

For example, you can sell the Oct 115 calls and collect about $390 for each.
  • Your net cost per share decreases from 117 to 113.10
  • If the calls expire worthless, it means the stock is below 115 (or else the call owner would take your shares by paying you 115), you can sell new calls.
  • If you do sell the shares at 115, you have a profit of $1.90 per share
    • If you prefer not to sell your stock, you can sell Oct 120 calls instead of Oct 115 calls.  The current price of these calls is $165.
    • You collect less money for these calls, but you gain the chance to make a larger profit and have less protection (only $1.65 per share vs 3.90).
The basic choice is:
  • pay for total extra protection, allow for unlimited profits: buy puts
  • collect cash and receive less protection and have limited profits: sell calls
Mark D. Wolfinger
Create Your Own Hedge Fund: Increase Profits and Reduce Risk with ETFs & Options