Ask Colin

Why do you not use put options as a protective measure in your investment plan?

When you ask about using put options as a protective measure, I assume you mean as a hedge against the price of a share falling. In very simple terms, this would be achieved by either buying an at the money put option for the number of shares held to lock in the current profit or an out of the money put option for the number of shares held to lock in a stop-loss situation. The advantage of this would be that for a small cost (the option premium), a guaranteed result could be achieved, without selling the shares.

There are three likely outcomes.

The first is that the price of the shares moves sideways during the life of the option. In this case, the result will have been to have reduced the current profit by the amount of the option premium.

The second is that the price of the shares rises. In this case also, the result will have been to have reduced the future profit by the amount of the option premium.

The third is that the price of the shares falls. In the case of the at the money option, the effect will be to have locked in the current profit less the cost of the option premium, by exercising the put option. You could also sell the put option for a similar, but not necessarily the same result. In the case of the out of the money put option, its result will vary depending on how far the price of the share falls relative to the strike price of the option.

This seems a lot of trouble to me. It only makes any sense if your tax rate on your investing is very high, so that you might want to avoid crystallising a capital gain, even if it is discounted 50% for holding more than 12 months (or if you bought the shares before capital gains tax started). If you are able to invest through a self managed superannuation fund, your tax rate should be quite low, or even non existent if you are 60 after June 30 this year.

There is also the issue of opportunity cost. If you spend a lot of time holding onto an at risk position by hedging, you reduce your profit and also forgo the profit you might have made by switching to a share with better prospects.

So, the big psychological trap in this hedging approach is that you avoid making a decision and it ends up costing you missed opportunities. To my mind, it is better to say that, if I am worried about a stock, I should take the profit and reinvest the money elsewhere while I see what happens. When the doubts dissipate, I can always buy the stock back again. Brokerage is cheap these days.

As asked, I have explained my thinking, but as always in investing there is no single right or wrong answer. Every one of us is different and we need to work out an investment plan that we are comfortable with. Hedging may well be right for your situation and temperament. I have considered it and come to the conclusion that it is not my optimal approach. A big element in that for me is the fear that it would make me lazy by the hedge being a psychological crutch to avoid making hard decisions. It has worked better for me so far to take a strictly logical and cold-blooded decision on each case and then move on.

By the way, there are other ways to hedge, but they are outside the scope of your question. My attitude to the alternatives would be the same as for put options.

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