Definition of a protective put:

A put option purchased for a stock that is already owned by the owner of the option. A protective put defends against a decrease in the share price of the underlying security. When a protective put is used in conjunction with covered call writing, the strategy is referred to as a collar strategy. A collar in options trading is the owning of the underlying shares while simultaneously selling the call options and buying protective puts. In a true collar strategy the puts and calls are both out-of-the-money having the same expiration dates and equal number of contracts. So we sell an O-T-M call and protect the downside by purchasing a put.

Example of a Protective Put/Collar Strategy:

• Buy 100 x Company XYZ @ $48
• Sell 1 x $50 call for $2
• Buy 1 x $45 put for $1
• Net gain on the option buy and sale is + $100 (200 – 100)
• This brings our cost basis down to $4700 (4800 – 100)

Outcome if stock prices surpasses the $50 strike price:

• Shares are sold for $5000 (50 strike x 100 shares)
• Results in a profit of $300 (5000 – 4700)
• ROO = 300/4700 = 6.4%

Outcome if stock prices falls below the $45 strike price:

• Shares are sold for $4500  (not $4300) because of the protective put
• Net loss is $200 (4700 – 4500) = 4.3%

Outcome if stock price remains @ $48:

• ROO = $100 (100/4800) = 2.1%

Chart of possible outcomes:

The profit potential is slightly muted due to the cost of the protective put but the downside risk is protected at the strike of the put.

Tax treatment of Protective Puts:

When the protective put is purchased on the same day as the stock, it is referred to as a married put for tax purposes. To calculate capital gains or losses, the investor adds the premium paid for the option to the purchase price of the stock to calculate the tax basis of the stock. For example, you buy 200 x ABC @ $30. On the same day, you purchase 2 x $25 puts @ 2. The tax basis of the stock is $6400 (6000 + 400).

The case against protective puts:

Let me premise these remarks by saying that there is nothing wrong with purchasing protective puts. I feel, however, that we can get our insurance for free by educated, well-calculated and common sense investing. Here is what the Blue Collar Investor System  does to alleviate risk without spending cash for insurance (protective puts):

• Select only the greatest performing stocks.
• Select equities in the best performing industries.
• Avoid earnings reports, the most likely cause of a radical share downturn.
• Avoid companies that report same store retail sales.
• Sell I-T-M strikes when market tone and/or stock technicals are compromised. In this case, the option buyer is paying our insurance.
• Use technical analysis to determine buy-sell points.
• Implement exit strategies when needed.
• Sell predominently 1-month contracts for better control.

The only time a protective put will benefit us over and above our system’s inherent protection, is when a stock drops precipitously in a short period of time. This can occur after an earnings report but we are already avoiding these reports. Otherwise, such events are few and far between. Therefore, in my judgement, it doesn’t pay to purchase a put every time you sell a call option. You’re just not getting enough bang for your buck as long as you do your due diligence and follow all the system criteria.

Technical Analysis of Recessions:

How frustrating is it to listen to the experts disagree with each other on the recovery of the economy in general and the stock market in particular? We are in a unique and historical time and so our financial futures cannot be predicted with the same degree of clarity we would see in normal market conditions. One concept this site has brought to focus recently is the fact that historically recessions show three distinct bottoms on their chart patterns. If history will repeat itself, then we are due for one more. Here is the chart of the S&P 500 during the recession of 1982. Note the three bottoms in September of 1981, March of 1982 and August of 1982:

Recession of 1981-1982

Now let’s look at the current recession which began in December of 2007. Note the bottoms that occured in November of 2008 and in March of 2009:

Recession 2007 to ?

So if you are a chartist and believe that history will repeat itself, your investments should be cautious and conservative. Most of you following this site have read my posts (ad nauseam) about utilizing I-T-M strikes when concerned about market tone and stock technicals. This site will continue to monitor the chart pattern of the S&P 500 (among other market indicators) to see how this ultimately plays out.

Last Weeks Economic News:

Housing sales disappointed in March after surging in February. The Conference Board’s Index of Leading Indicators fell a worse-than-expected 0.3%. On a positive note, it is no longer dropping precipitously. Demand for durable goods also disappointed by dropping by 0.8%. For the week, The S&P 500 was down 0.4% for a year-to-date return of – 3.3%.

Best in investing,

Alan

alan@thebluecollarinvestor.com