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Buying Puts



Note: This column is offered in the vein of education and is not intended as advice. Financial options are risky vehicles and should only be traded by professionals who understand those risks.

It is hard to find anyone bearish these days, those willing to wear a scarlet "B" on their forehead. As you know, even though I am bearish on fundamentals, I don't really commit fully to that tenet: market direction in the short run, which can be a year or so, is heavily influenced by liquidity and market sentiment.

Market sentiment can cause the market to ignore bad news. The last jobs report took the equity market by surprise and sent it down over 130 points. After some cheerleading and a few shots of liquidity, that data point was quickly forgotten and the market resumed its march upward.

Market sentiment can also cause the interpretation of bad news as good. The merger of JPM and ONE is looked upon as a positive by the Wall-Street sales machine. We don't see anything really positive about it. An excellent source of mine tells me that ONE was passed over by BAC because of a bad credit card business. That may or may not be true, but regardless, I view the merger as one of weakness: one where it is easier to hide problems in one big balance sheet than in two smaller ones.

Because Scott pointed out last week the preponderance of trigger points that exist for a good stiff correction and because several Minyans have asked for the best way to buy puts on the market, I thought I would take my hat off so that you could see my big red B.

Equity puts are bought for one of two reasons: hedging (although I will qualify this later) equity exposure or speculating on a decline in the equity market to make money. I have gone over the mechanics of put buying and you can review those in past articles. I just want to spend a minute on different ways to allocate the premium cost.

First understand that buying puts is pure market timing: the protection (speculation) afforded in the put lasts only to expiration. Buying puts is like buying insurance for once the premium runs out, so does the insurance. You have to keep paying premiums for it to remain in effect. For an individual, buying insurance like home owners or life insurance is a very significant cost over one's life (if most people took the time to add it all up, they might be horrified). Very few people buy insurance for a while, then cancel it for a while, then buy it again in order to try to control the cost. They know that there is a risk of accident during the times when they would not own it.

But this is precisely what you are doing when buying puts: buying only periodic protection where a decline could occur during the times when you don't own puts. This is why it is highly speculative.

Because there is a good chance that you will lose all of the premium paid in buying puts, you must not consider buying puts as insurance, even when hedging, but more as pure speculation. The most important thing of all then, is to determine how much you are willing to lose for a reasonable pay-off.

This makes buying puts tantamount to a bet, one where you lose a certain amount for a certain probability adjusted pay-off. Because market sentiment is so influencial and indeterministic, I would use a one-year time horizon when deciding to buy puts. The actual time horizon could turn out to be much shorter, but to try and use a shorter time horizon in my mind would be very costly.

So let's say you are looking at the market now and decide that it should make at least a ten percent correction over the next year. You decide that instead of selling your equities, because option prices are fairly cheap, you decide instead to buy market puts.

The first step is to decide the total amount to bet for one year as a percent of your total capital. I will venture that if anyone spent more than 1% to 3% of their total capital speculating on put buying and lost it, they would be quite upset.

Once you decide on how much you are willing to lose, stick to it. Do not spend more or less over the next year.

Once you have decided on the total premium to be spent, you can allocate it in one of several ways (and you can come up with slight variations among these):

1) Spend all the premium and buy March puts now
2) Buy March puts, wait until they expire, then buy June puts, and so on
3) spread the premium and buy March, June, September, and December puts all at the same time
4) Spend all the premium on just December puts now.

Each scenario has a different pay-off that is dependent on if, when, and how the market declines. Method two is the most flexible because it allows for market appreciation. In general these allocation methods become less risky with less pay-off sequentially (1 has more gamma and less vega than 4), but see if you can imagine how each will play out as the market unfolds.
The important things are to plan ahead and stick to it.

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