Options : Puts

How to use Puts to cover your downside risk

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A few weeks ago we talked about risks and returns, and how to think about two different investment options (NASDAQ and Bitcoin), with wildly different risk profiles. It’s not just about how much returns you made, it’s about how much risk you took to make that return - we call this risk adjusted returns

One way to protect your returns, is to pair the stocks you own with - options. Years ago, I learned this from Axe (above) and Taylor (below) - in Billions

A Love Letter to Billions

Eight years ago, The New Yorker had a brilliant piece on Damian Lewis, as he was preparing to play the, now legendary and infamous hedge fund manager - Bobby Axelrod (or, Axe) in Billions. Billions became a cult classic in New York City by flawlessly creating a melting pot with ingredients of naked ambition, regulatory politics (the SEC), finance, and of course - the grit and grime of Manhattan

There is an unbridled intensity to it that has hardly ever been matched by other shows. There is unapologetic aggression too, and Taylor Mason can attest to that. Billions can only work in a place like Hong Kong, London or New York. Think of it as - Martin Scorsese meets Christopher Nolan, but for finance

It was a shot of high-stakes financial adrenaline (here) you can unapologetically overdose on, you had to be in the moment and not multi-task because it taught you things too, it was flawless … and so was Damian Lewis’ American accent

Billions taught me you can look at the entire world using math, probability, statistics, and finance, and you can connect the dots for a realistic outcome (making money of course). Reductively speaking, if there is a potential downpour, invest in firms making umbrellas, and do hedge it, just in case it does not rain

Billions taught me to pair options with stocks : when you invest billions of dollars in stocks you need to protect your downside risk, and the same intuition applies to our albeit smaller, individual investment portfolios as well

What are Options ?

Options are essentially financial contracts that let you (in this example) - sell an asset, on or before a specific date in the future, at a specific price, regardless of what the market price of that asset is. You obviously spend to buy options

Options and Downside Risk

There are a few ways to use options, but this is one way to use it, when you just want to cover your downside risk

You can essentially buy two things, what we call as PUTS and CALLS (they are both options). In this case, we’ll only talk about PUTS

Why buy PUTS ?

Apple is trading at $ 190 as of 5/29. Apple has been up and down this year, mostly because they haven’t really had a materially significant invention in a few years, and they are scrambling to get on pace with generative and iOS-integrated AI

Great. So, if you buy 100 stocks of AAPL at $ 190, you’d spend $ 19,000. You need to protect that investment. With geopolitical grandstanding between the US and China, tariff threats and November elections, we don’t know what’s going to happen in the stock market, no one does

So yes, you do need to protect your investment, and for that, you need PUTS

What are PUTS and How PUTS Work ?

PUTS are a type of options and they are financial contracts. You can buy PUTS (at a price) from your brokerage firm. Imagine you buy PUTS for the date 12/20 and for a strike price of $ 190 (strike price is essentially the price at which you have the option of selling this stock)

You need to spend money now to buy those PUTS - so that is the maximum amount of your loss in this trade. Each stock will have what we call as an options chain, and you can access them on your brokerage firm and NASDAQ

In this case, am not worried about locking in my upside gains, rather, I am only interested in covering my downside risk i.e. even if the stock drops below 190 by 12/20, I want to be able to sell it at $ 190, on or before 12/20

Each options contract is for 100 stocks. Below, inside the dotted red box, is the strike price and corresponding spend for options contract, and you’d spend (9.95 x 100) = $ 995 today, to buy options, to be able to sell 100 AAPL stocks at $ 190, on or before 12/20

and most importantly, you get to sell AAPL at $ 190, regardless of the market price of AAPL until 12/20

(NASDAQ Options Chain for AAPL - here)

You just covered your downside risk by spending money (and that $ 995 is the maximum amount of money you’d lose, because you have locked in your selling price)

Net Gain

If AAPL increases to $ 220 by 12/20, then you gain naturally and will not exercise your options contract of selling your stocks at $ 190, and all you have lost is the total of $ 995 you spent in buying options

But, if AAPL drops to $ 170 by 12/20, then you’d be glad you bought these options. You will exercise your options contract and sell it at $ 190, and you would realize a net gain (net gain, because we deduct the money you spent buying options, from your total gain)

Net Gain =

((Strike Price - Market Price)*Number of Stocks) - Money you spent for options contracts

((190-170)*100) - $ 995 = $ 2,000 - $ 995 = $ 1,005

If AAPL drops to $ 165 by 12/20, then your net gain becomes

((190-165)*100) - $ 995 = $ 2,500 - $ 995 = $ 1,505

and if AAPL drops to $ 160 by 12/20, then your net gain becomes

((190-160)*100) - $ 995 = $ 3,000 - $ 995 = $ 2,005

In summary, when you hold significant amount of stocks that have appreciated in value over time, you essentially pair them with options to cover your downside risk

Next week, we’ll talk about how to use options for the upside, it’s very similar to how we would think about marginal benefits and marginal costs, and how they both feed into estimating net present value in micro-economics

as we say in Billions - thanks Axe !