Day Traders and Swing Traders and Options? Maybe!
Typical day traders and swing traders look for stocks with quick, short term movements, and are not in the business of holding positions overnight let alone a week or two. So the use of options has not usually been a component of their trading strategies.
Now however, some new opportunities for profit are available since many day trading firms are allowing their traders to trade options. Unfortunately, many option strategies do not apply to the quick in and out nature of day trading. Neither day traders nor swing traders are typically in a single stock long enough for the strategy of selling options for premium collection to be viable.
Since these traders often look for break-outs, and sometimes go bottom fishing to find opportunities for profit, a premium paying option might work well for them. Why? Because the trader would be buying protection from catastrophic losses. Bottom fishing and breakouts are associated with volatility, which means uncertainty and risk. However, there is a strategy that will provide the necessary protection for these traders to carry positions through overnight risk, while remaining fully protected. This would still allow also them to take advantage of the large potential upswing that was the original goal of identifying the bottom and the break-out. This strategy is called the protective put.
THE PROTECTIVE PUT
The Protective Put Strategy involves the purchase of put options in combination with the purchase of stock and works well in situations where a stock is prone to rapid, volatile movements.
A put option gives an owner the right, but not the obligation, to sell a certain stock, at a certain price, by a specified date. For this right, the owner pays a premium. The buyer, who receives the premium, is obligated to take delivery of the stock should the owner wish to sell at the strike price by the specified date. A strategically used put option offers protection against substantial loss.
The protective put strategy is a strategy that is ideal for a trader who wants full hedging coverage. This strategy is very effective in stocks that normally trade under high volatility, or in stocks that normally do not trade under such high volatility but may be involved in an event driven, highly volatile situation.
When an investor purchases a stock, they can buy the put (protective put) to provide a proper hedge. The construction of this position is actually quite simple. You buy the stock and you buy the put in a one to one ratio meaning one put for every one hundred shares. Remember, one option contract is worth 100 shares. So, if you buy 400 shares of IBM then you need to purchase exactly four puts.
From a premium standpoint, you must keep in mind that by purchasing an option, you are paying out money as opposed to collecting money. This means that your position must “outperform” the amount of money that you paid for the put. If you were to pay $1.00 for a put and you owned stock against it, the stock would have to increase in price $1.00 just to break even. The protective put strategy has time premium working against it, thus the stock needs to move to a greater degree, and more quickly, to offset the cost of the put.
When we buy a stock, three potential outcomes exist. The stock can go up, go down or it can remain stagnant. If we were to analyze the three scenarios, we would find that only one scenario, the up scenario, can produce a positive return and that’s only when the stock increases more than the amount you paid for the puts. The other scenarios produce losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes down, you lose again- but the loss is limited. It is the limiting of loss in highly volatile situations that makes the protective put an attractive and useful strategy.
This is how it works! Imagine you buy stock for $31.00 and buy the 30 strike put for $1.00. If the stock goes down, the position will produce a loss. For example, if the stock is down to $30.00 (down $1.00) at expiration of the option, you have a $1.00 capital loss. With the stock at $30.00, the 30 strike puts will be worthless, thus you incur a $1.00 loss because that is what you paid for the put. Your total loss will be $2.00. Using the protective put strategy set a cap on your losses. The put strategy’s attractiveness is that it will allow you to set loss limits!
Let’s see how that works. We’ll set the stock price down to $28.00. Since you purchased the stock at $31.00, there will be a capital loss of $3.00. The puts, however, are now in the money with the stock below $30.00. With the stock at $28.00, the 30 strike puts are worth $2.00. You paid $1.00 for them so you have a $1.00 profit in the puts. Combine the put profit ($1.00) withthe capital loss ($3.00) and you have an overall loss of $2.00. The $2.00 loss is the maximum you can lose no matter how low the stock goes because the buyer of your put must take the stock at the strike price. This is the protection the put provides.