Puts For Protection – Update

I’ve done a series articles in which I described the use of put options as a protection against losses on holdings of stocks or exchange-traded funds.

Today, we’ll do one last update on this theme to show that the option trading strategy worked as planned.

In the original article I used the example of a 100-share position in SPY, the exchange-traded fund that tracks the S&P 500. At that writing on September 11, 2018, SPY was at $289.33 per share. The put that we looked at as protection was one at the $265 strike that was due to expire six months later, in March 2019. In September that put was priced at $4.91 per share. The 265 strike was chosen so that an arbitrary 10% loss was the worst case scenario if SPY went down.

In the update in January 2019, we noted that by December 24, 2018 SPY had indeed melted down from $289 to $234, a drop of $65 per share or almost 19%, the worst fourth quarter for the stock market since the Great Depression.

This was a great stress test for our $265 protective puts. We showed that the puts that we had selected three months earlier to limit our loss to no more than 10% of that $289 original price, had done exactly that. Rather than the full 19% that SPY had dropped, our loss to that point would have been exactly 10%, if we had liquidated. That was all we could possibly lose no matter how much further SPY dropped, even to zero. Our put options were now earning a full dollar per share for every additional dollar that SPY dropped, completely canceling out any further losses, no matter what.

At this point in December 2018, the March 2019 put options that we held still had three months until they expired. There was no need to liquidate the SPY position before March, since the loss could not possibly increase so we were free to hold it and the puts until March. It was possible that SPY might recover somewhat, and our loss might even be less than the 10% worst-case result we now had.

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