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No matter how bullish the stock market may look at a particular time, you should always diversify your portfolio with a few uncovered (or "naked") put purchases. This week, we offer advice on how to pick the puts that are right for you.

Varying Bearish Positions

When you buy a put, you pay a premium for the right, but not the obligation, to sell the stock at the strike price anytime until the expiration date. By itself, a long put constitutes a bearish position, one that is designed to make money if the stock declines. If the stock rises, the most the investor can lose is the premium paid. This is because you do not have to sell the stock at the strike if the stock is above the strike. (You may also combine puts with the underlying stock to create what we call a "married put." We described this strategy in our report, "Hedging Stocks with Married Puts.")

As with calls, puts can be in-the-money, at-the-money, or out-of-the-money.

An in-the-money put is one in which the strike price is above the stock price. This put has what we call intrinsic value since the put holder can buy the stock at the lower market price and sell it at the higher strike price. The remaining component of the put premium is its time premium. Think of this time premium as deductible insurance against making the wrong decision. The more the put is in-the-money, the more you can lose if the stock goes the wrong way (i.e. up) and the lower will be your time premium insurance.

In Graph 1, we show an example of an in-the-money put, the Marvel Entertainment September $22.50 put with the stock at $20 and the premium at $3.05. With 158 days to go to expiration, the option consists of intrinsic value of $2.50 and time premium of $0.55. The most you can lose on one put option (on 100 shares) is $305. This happens if the stock ends up above $22.50. If the stock stays at its current price of $20, the option will still be worth its $2.50 intrinsic value at expiration. In this instance, the most the investor will have lost is the original $0.55 time premium (or $55 on a 100-share contract).

03-10-10 Buying Naked Puts - Graph 1

 

If you are very bearish on the stock, but you want to limit your losses should the stock rise rather than fall, you should buy an in-the-money put.

An at-the-money put is one in which the strike price is equal to the stock price. As the stock goes down, the put immediately begins to pick up intrinsic value. Alternatively, if the stock rises, the put has no exposure other than the time premium paid.

In Graph 2, we show an example of an at-the-money put, the September $20 put at $1.50, also on Marvel Entertainment. Since the strike price is not greater than the stock price, this put option has no intrinsic value. In this example, if the stock ends at the $20 strike or above, the investor loses the entire premium. If the stock declines below $20, the investor will reap the put's intrinsic value at expiration, but he/she will have lost the time premium.

03-10-10 Buying Naked Puts - Graph 2

 

At-the-money puts have higher time premiums than do in-the-money puts or out-of-the-money puts. This is because you are in a sense buying coverage in both directions with no deductible. If the stock falls, your profits kick in right away. If the stock rises above its current price, the most you can lose is the $1.50 premium ($150 on a 100-share contract).

An out-of-the-money put is one in which the strike price is below the stock price. Here you are buying insurance against missing out if the stock declines by a large amount. At the same time, your losses are quite low if the stock does not decline, or if it rises.

In Graph 3, we show an example of buying the September $17.50 strike put on Marvel Entertainment at $0.55. Notice that the stock has to be below $17.50 at expiration for you to reap a profit. On the other hand, if the stock does not move, the most you will have lost is $0.65 (or $65 on a 100-share contract).

03-10-10 Buying Naked Puts - Graph 3

 

You want to buy out-of-the-money puts to insure that you do not miss an especially large decline in the stock. In a sense, you are buying cheaper insurance on something that may never happen.

Our Put Buying Picks

Our model bases its put buying recommendations on a combination of the common stock rank and the pricing of the put itself. If the common stock rank is sufficiently low and our model calculates the put to be underpriced, then we are likely to recommend the put for put buying. However, some puts can be so underpriced that our model will rank them for put buying even if the underlying common stock rank is neutrally ranked. In Figure 1 (on page 3), we show the results of screening for rank 1 puts that are between 10% and 6% out of the money and that expire in January 2007. Our screening found 26 different puts on 23 different stocks in 17 different industries. All were underpriced, according to our model.