Stock defence is an interesting subject which receives scarce coverage in the media. All of us have ended up buying stock only to see it go down or trade sideways for days or weeks.
The question is what can we do about it? One popular coping mechanism is buy the dip (cost averaging). It’s simple and easy. The results are good as long as the stock rebounds.
But what if it doesn’t, is there anything else that we can do to protect our interests? Read on to find out what we can do with options.
We’ll be using American options and US stock but the methods are universally applicable. If you don’t know how options work you can read this first.
Why managing losses is important
No one wants to lose their hard earned cash. We all invest to grow our assets. Unfortunately sometimes things go sour which can be demoralising for the investor. You may start to question your knowledge or decision making ability.
But usually it’s not you, the market just changed. Your choices may have been really good at the time but new information came in and things took a turn for the worse.
Rare events like market crashes happen more often than statistics imply and individual stock is even worse. It is difficult to beat the market but we all want to give it a shot.
The result is that we buy stocks and some are pure profit while others can underperform for years.
The main problem I see are drawdowns on the account. Here’s what happens if you lose a selected range of percentages:
|Loss||Profit needed to break even|
It is clear that the more you lose the harder it is to get back in the game.
Today we’ll try to cut down these losses with options but first let’s have a look at the most common cost basis reduction method.
Buy the dip
For those unfamiliar this means buy more shares to cost average the price.
When you buy the dip you reduce your cost basis. For example, I buy a share for £10 and the price drops to £8. If I buy one additional share the average price drops to (£10 + £8) / 2 = £9. Then, the stock drops to £6, I buy one more and I get an average price of (10+8+6)/3 = £8.
Clearly the disadvantage is that I’m still down (£8 – £6) x 3 = £6 on my £24 investment. However, if the stock goes back to £10 I’ll bag a £6 profit.
I prefer to call this cost basis reduction rather than stock defence. The latter implies a more active approach which is the subject of the following sections.
Stock defence with options
Options are less capital intensive than stock. In the above example we had a budget of £24, but what about defending 1,000 shares or even 100.
Your 1k shares are worth £10,000 and you need to find another £8,000 for the next batch. What if you have 6 similar positions all losing money?
Before we start I have to explain something really important.
Delta is the change in the price of an option relative to a $1 move in the underlying stock.
For, example if we have a 30 Delta option priced at $1 (or $100 per contract) it will gain or lose $0.30 (or $30 per contract) for a $1 move in the underlying stock.
I could say that a 30 Delta option has a similar effect to 30 shares of stock. However, this is not true as the option Delta changes.
Each share of stock has 1 Delta which always remains constant while the option’s Delta increases or decreases based on the price action of the stock. You can find a more detailed explanation here.
Buying put options
The first ever stock and options hedging strategy I heard of was to buy a put. You buy a put option and you know that your downside is capped.
This never made any sense to me because it costs money. I can see the point in terms of hedging an investment but you chip away from the upside. Below is the payoff from 100 shares of XLE, a low priced energy ETF, and a 32 Delta put. All screenshots in this article are from the Tastyworks software and show the prices of the options at the end of the trading day.
We buy 100 shares for $28.92 and a put for $113 per contract covering 100 options ($1.13 per option) for a total of $3,005. Therefore, XLE needs to go up by $1.13 or 3.9% before we start making any money.
The defensive capabilities of the put option really kick in after the stock drops below $27. We can the exercise it, sell the shares for $27 and cap our downside to a total of $305. This is a 10% loss.
Or we can sell the put option and the shares to capture some of the extrinsic value of the option. We may get an extra $0.50 per share. This is the reason why it is better to sell a long option rather then exercise it.
Overall, we give up 4% of potential upside to cap the maximum loss to 10%. We can forget about the cost of the put and think about the Delta instead.
The stock has 100 Delta but our put has -32 Delta so we end up with 68 Delta or 68% of the directional exposure of pure stock.
As the stock goes up the put Delta increases towards 0 and we start to benefit more from the up-move because the overall position Delta will increase towards 100.
If the stock crashes to $19 the next day we’ll end up with a -95 Delta put option and 100 stock Delta adding up to a total of 5. Therefore, most of the directional exposure was absorbed by the put option.
You can try to buy the dip with a put option
Instead of buying the dip you can sell a put option. You take on the obligation to purchase the shares at the strike price.
Therefore, if you fancy XLE but you’re only prepared to pay $27 for it you can sell the corresponding put for $110. You’d end up disappointed if it never trades for this price but you’ll get the option premium as a consolation.
However, if XLE drops to $26 you end up buying it for $27. You were already paid $1.10 per option which brings 10 cents per share.
You start losing out if XLE drops below $25.90. Nevertheless you’d have lost $3.02 per share had you bought it outright.
The downside is that we increase the directional exposure of the position. If we sell the -30 Delta put we end up with +30 Delta and 100 stock Delta. We now have an extra 30% directional exposure.
In conclusion, this is only viable if you are happy to buy more stock. In terms of stock defence it will work great if the option expires worthless.
The covered call: first line of stock defence
Selling call options against the shares is a more appropriate form of stock defence. It is consistent with the cost basis reduction mechanics. However, the advantage is that it doesn’t require any additional capital.
Here is how a covered call is set-up if you don’t own any stock. For example, you are thinking of buying XLE but you are worried it may lose value:
This is one of the simplest options strategies. I buy 100 shares of XLE for $28.92 each and I sell the $31 strike call for $1 per option.
Consequently I pay $27.92 per share altogether and I take on the obligation to sell my shares for £31 each should the option be exercised. I will realise a profit of $3.08 per share or 11% over 52 days.
Assignment of the shares will occur if XLE trades over $31 at expiration or shortly before. If it doesn’t I keep the shares and the $100 option premium bringing the price I paid down to $27.92.
If XLE trades for $29 at expiration you make $1.08 per share instead of $0.08.
Usage for stock defence
Something like that will work if you bought the shares for around $31 and you seek to make $100 from the options. If you bought them for a lower price you profit from the share price increase too, e.g. add $100 if you bought them for $30.
If you get assigned your shares are called away and you earn the $100. You can always buy them back if you think there’s more upside.
However, if XLE keeps trading below $31 you pocket $100 and you reduce your cost basis to $30 per share. Repeat until you break even or make a profit.
The $31 strike call has 35 Delta, however, we sold it so we are short or -35 Delta. Consequently, our directional exposure is 100 – 35 = 65 Delta or 65% compared to stock.
If XLE keeps going down the option Delta will start increasing towards 0, therefore, our position Delta will start increasing back to 100. We’ll make money from the option but the stock will keep going down.
In the opposing example XLE will keep going up, the short call delta will become more and more negative. When it reaches around -55 Delta any gains from the stock position will be completely offset by the option’s losses. This is when we realise the max profit of $308 from the screenshot example.
Note that the Delta of the option can’t exceed the one of the stock, therefore, the aggregate Delta of the position may become close to 0 but it will never be negative.
You lose your shares if you get assigned. The stock may keep going up which presents you with a loss in terms of the missed opportunity.
The implication is that the strategy is suitable for stocks which are expected to trade sideways or if you want to sell the shares for a specific price.
You shouldn’t sell a call option if you expect significant upside.
XLE actually dropped in price while I was writing this. Let’s see what happened:
The stock lost $1.21 per share, however, the $31 strike call gained $0.14 per option because we sold it for $100 and we can buy it back for $86.
The result is a net loss of $107 instead of $121. So we protected 11.6% of the downside today.
The profit from the options will only be realised if you close the position. Otherwise it is a paper gain or loss.
If you bought the $27 strike put you would have gained $1.79 – $1.13 (the price paid) = $0.66 per share. It is a more effective hedge because it shields 54.5% of the loss. However, XLE could have gone up too.
The buy the dip approach via selling a put would have resulted in a paper loss of $66. You don’t need to worry about this because you just collect your shares if you are assigned. Otherwise, the option will eventually end up worthless and you keep the original $110.
The Short Strangle: second line of stock defence
The short Strangle is a direction neutral strategy where you sell a put and a call. It is profitable when the stock remains rangebound between the two strikes. The strategy is Delta neutral because the put and the call offset each other initially.
We’ll use the Strangle for stock defence so our situation is slightly different. But first let’s see how it works:
It’s a mixture of buy the dip and a covered call. To recap, we bought XLE for $28.92 and it’s down $1.21 (4.18%) to $27.71 in a day. Now we want to do something about it.
If we sell the Strangle as a standalone strategy we want XLE to stay between $25 and $31. As you can see we start losing money if it breaches $23 or $33.
However, we have the 100 shares so our call side is covered. Therefore, if there is a breach at $31 we stand to make $184 from the Strangle and $208 from the stock or a total of £3.92 per share. That’s not too bad 13.55%.
The Strangle in the example has about 70% probability of profit.
Not so great scenario
The problem is if there is a breach on the downside as we’ll have to buy 100 shares for $25. So the purpose of selling the put is not to get assigned but to make an extra $101.
This strategy will be perfect if we anticipate that XLE will trade somewhere over $25, for example $25.50. Then had we not tried to deploy stock defence we’d be looking at a loss of $3.42 per share or 11.82%.
We were proactive and collected $1.84 per share from the Strangle so we reduced it by over 50%!
But what will happen if there is a breach and XLE is trading for $24 at expiration. We’d buy 100 shares for $25, therefore, we now have 200 shares bought for an average price of $26.96.
We also collected $1.84 from the Strangle, which brings the average cost down to $26.04 (26.96 – 184/200 shares). Overall, we’re down $408 = ($24 – $26.04) x 200 shares. Had we done nothing the loss on 100 shares is $492.
If it’s taken so long and the initial investment is still down 17% I’d suggest we get rid of it by selling more calls against the shares.
Our call option is covered meaning that we don’t have to put up any collateral to sell it. This is not the case for the put as it will require about $300 of buying power in a margin account.
But the main issue is that we may end up with 200 shares. What if I don’t want any extra shares?
I can choose a put option with a lower Delta or defend it but this just makes things more complicated. Sometimes simple is better like the covered call.
Our Strangle’s Delta is -3 which means that we are not getting any directional advantage. The overall position Delta is 97 so I see it more like two strategies: a covered call and a short put.
The short put option adds 30% directional exposure to our stock leg.
Therefore, the main risk is if XLE crashes something like 50% because it will be indefensible. In the example we had a 17% loss which is manageable, however, a large one will move the options we need way out of the money.
If XLE is trading for $15 the $30 strike calls will cost something like $5 per contract. We can still sell them but we’ll make $0.30 per share per year. It’s not worth it.
The Short Straddle
This is another Delta neutral strategy only this time we are selling at the money call and put. This is the pay-out:
We sell the $28 strike call and put, we have 100 shares we bought for $28.92 and XLE is trading for $27.71. It’s down $1.21 but we’re going to pick up $4.20 per share from the Straddle.
As you can see this strategy starts to lose money if XLE goes below $24. Similar to the Strangle we are covered on the call side.
If XLE is trading above $28 at expiration we pick up $4.20 – $0.92 ( we bought it for $28.92) = $3.28 per share or 11.34%. We’d be missing out on any upside though as the shares will be called away
The ideal scenario is if XLE ends up trading for $28.00 at expiration because both options are worthless. We keep our shares and the option premium.
Not so great scenario
Our risk is always to the downside whenever we buy stock. The Straddle is no exception because we have exposure from the shares and the short put.
It’s not as bad as it sounds depending on where XLE ends up exactly. If it trades for $26 at expiration we just buy 100 shares for $28.
Now we have 200 shares bought for an average of $28.46 but we picked up another $420 from the Straddle or $2.10 per share. The final result is a cost basis of $26.36.
If you’re not tired from stock defence yet you can wait for XLE to pick up some steam and sell it or sell more calls until you get rid of it. And if you really don’t want it anymore you can just take a $72 loss on 200 shares.
In the do nothing scenario we just lose $2.92 per share or a total of $292.
Worst case scenario
Let’s compare it to the Strangle and assume XLE breaches the $24 strike. Then we lose money from the shares and the Straddle.
We’ve got a $492 loss from the original 100 shares, then we’ll have to buy another batch for $28. Overall, we’re down $4.46 per share – $2.10 we got from the options = $2.36 or $472 in total.
The only positive thing I see is that we have 200 shares instead of 100 for a similar loss. We’ll have to wait for energy to make a comeback or find some decent priced $28 strike (or over) calls to sell.
Adding a long put to the Straddle
There is the option to protect the downside of the Straddle by buying the $27 put for $1.80. However, we’d only get $2.40 per share from the strategy.
Therefore, the potential upside profit would be $2.40 – $0.92 = $1.48 per share if they are called away.
In terms of downside protection we’re looking at about the same gain if the $27 gets breached. We’re only left with the money from the call and we have to cover the loss on the put side too. Nevertheless, we still reduce the overall stock loss by $1.40 per share.
The advantage is that we don’t end up with an extra 100 shares. But even then you could have just sold the call for $2 instead of adding two additional legs.
They are similar to the Strangle, we need collateral on the put side and we can end up with more shares we don’t want.
The Straddle risk is greater because the put strike is right at the money. I think that this is viable only if you think XLE is making a small comeback or you want to buy more shares for $28.
In conclusion, the Strangle seems more suitable for stock defence because we have less risk on the put side.
The Straddle has -4 Delta so we don’t get any directional advantage from it and it suffers from the same disadvantages as the Strangle.
It is a bit more unfortunate that we have higher exposure on the put side because it has 49 Delta. So there is also higher downside risk.
The Protective Collar
The collar is less aggressive than the short options strategies because there is no risk associated with it on the options side. It looks like this:
We sell the $30 call and buy the $25 put to get $0.10 per share. It’s not much but we’re not paying anything so it can’t be that bad.
If we get a breach at $30 and get assigned we just pick up $1.08 per share + $0.10 = $1.18. And then we sell the put for whatever it is worth at the time, even $0.10 – $0.20 per share will make a difference.
If we get a breach at $25 we can exercise the put or better sell it together with the shares to cap our maximum loss.
If XLE trades for $25 or over within the next 3-4 weeks we may make a variable amount but I’d be surprised if it exceeds a loss reduction of $1 per share. The small gain occurs because the put will increase in value while the call will be cheaper.
On a positive note we don’t care if XLE goes down to $1, we can still sell the shares for $25.
The Delta is -63 so we get a significant reduction of directional risk. The total position Delta will be 37.
No wonder it’s called a Protective Collar. If you’re setting up one make sure to carefully chose the strikes to maximise value for money.
The Stock Replacement: on the offensive
Sometimes the best stock defence is offence. I already talked about buying the dip by selling a put but you can buy a call too.
XLE is down $1.21 so the call options are down too! You can buy one or two at a discount if you think there is going to be a reversal.
You have 100 shares and the 36 Delta $30 strike call costs $1.15. If you sell 8 shares you can buy 2 calls and you lose $9.68 on the stock. It works out at about $1.20 per call.
If XLE prints $32 within the next month or so you’ll make about $300 from the options and 92 x $3.08 = $283.36 from the stock adding up to a total of $583.36. This is almost 100% increase over a pure stock position’s $308 profit.
You need to be confident that the stock is going up to use the stock replacement strategy.
The downside is that if it doesn’t you’ll lose $240 as your options will expire worthless. You can always sell a call which is further out of the money, for example the $32 or $33 strike, to reduce your cost by capping the upside.
Buying a $30 call and selling a higher strike one is a standalone options strategy called a long call spread.
Stock defence is not a one size fits all approach and it won’t necessarily shield you completely. Unfortunately all of the methods bring the best results if you intervene early. A 50% or 75% drop in the stock price is indefensible.
The market can be unpredictable which makes it difficult for all of us to time our trades perfectly. Therefore, I will write a follow up once the options discussed in this article expire and we know what the realised outcomes are.
Stay tuned for the results which will come out on the 18th of December are now available here.
Despite all the uncertainty we found out that there are a few methods to choose from. They have various pay-outs and risk profiles which gives choices to investors.
I talked a lot about getting assigned additional shares. This is the absolute worst case scenario and is not meant to happen often at all.
All we want is to collect the money from the options. Nevertheless, any options strategy carries risk so you need to have some capital on the side should the worst happen.
Stock defence strategies overview
The covered call is the easiest and the least capital intensive strategy because it is the same as doing nothing except for the capped upside.
Strangles and the Straddles are similar but I think that the former is more suitable for stock defence purposes because it carries less risk and is less capital intensive.
A long put and a protective collar are related too. The only difference is that you cap your upside to reduce the cost of the put option when you set up the collar.
The stock replacement strategy is on the offensive side because we pay money for it. One issue I see is that we can just end up losing more. You need to have a strong conviction that your directional assumption is correct to use it.
If you just want to buy the dip consider selling put options. You may be able to buy the stock at the price you want and you get paid for it.
I hope that this article was helpful. It is never a bad thing to look into the options which are available to you.