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"Why Not OTM Puts For Married Put?"



Question By Dan

"Why Not OTM Puts For Married Put?"

Why do you recomend buy shares with a delta of 100 and buy for example put at the money with a delta of 0.5. It does not make any sense ? Why do you not recomend to buy shares with delta 100 and buy put with o.25 or 0.15 delta ? What is the different or where is the problem for a strategie like that ? Sorry when I asked skeptical.

Asked on 19 August 2009

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Answered by Mr. OppiE

Hi Dan,

What you just described in your question is a married put options trading strategy where you buy the stock and put options simultaneously. In this strategy, put options are bought and held as "insurance" against a drop in the stocks that you own. Yes, a form of hedging. I believe you were asking me why At the Money Put Options (options with delta of 0.5) are "recommended" rather than Out of the Money Put Options (options with delta lesser than 0.5). First of all, to clarify, married puts can be executed with both at the money put options or out of the money put options. The difference is really in your specific situation and your intention. To understand the difference, lets look at an example.



Assuming you bought 100 AAPL shares at $160 today and the market feels slightly overbought. Even though you intend to hold the shares for a long period of time, you are also concerned about a dramatic drop in value on your position should AAPL shares ditch along with a possible short term pullback in the market. You want protection as long as AAPL goes below $160. You take a quick look at the near month AAPL $160 at the money put options and it costs $1.30. You rationalise that if AAPL should rise, it will definitely rise more than $1.30, thereby covering the cost of this protection. And if AAPL should fall, this $1.30 protection will completely hedge against the loss in the AAPL shares. You bought the at the money ( delta 0.5) put options. Lets see what happens next...

Assuming AAPL ditches to $140 as you have expected by expiration of the put options. Your AAPL shares lost $2000 in value while your put options gained $2000 in value. Your position is completely protected with just $130 paid. $130 to avoid $2000 of losses seems like a pretty clever choice.

Assuming AAPL continues to rally to $170 by expiration of the put options. Your AAPL shares gained $1000 in value while your put options which cost you only $130 to buy expires worthless. You still net $870 in profit.

Now, assuming the same scenario above but you chose to buy lower delta out of the money put options. You took a look at the near month AAPL $140 at the money put options with only delta of 0.10 and asking for only $0.30. You bought these put options. Let's see what happens next...

Assuming AAPL ditches to $140 as you have expected by expiration of the put options. Your AAPL shares lost $2000 in value and because the strike price of your put options is also $140, it becomes worthless as there are no intrinsic value gained. Overall, you lost $2000 and the $30 you put into buying the "protection".

Now assuming AAPL continues to rally to $170 by expiration of the put options. Your AAPL shares gained $1000 in value while your put options which costs only $30 to buy expirations worthless. You still net $970 in profit. Which is of course, higher profit than the at the money put options.

As you can see from the illustrations above, the decision to buy at the money put options or out of the money put options is largely governed by how deep a correction you expect the stock to take and how much protection you want. It is never a decision based on delta values. If you want more protection, you would have to buy at the money put options and if you want lesser protection, you could buy further out of the money put options. Also remember this, delta values are also a reflection of the probability of the option going in the money. If you buy a far out of the money put option with only delta of 0.1, you are telling yourself that this protection works only about 10% of the time and you would have lost the difference between the stock price filled and the strike price of the put option before that happens.




In conclusion, there is no standard or "recommendation" as to which strike price you should buy put options at for a protective put or married put options trading strategy. The decision should be governed by your expectation of the behavior of the stock and how much protection or risk control you want to build into your positions. In options trading, there is rarely a "one size fits all" recommendation.

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