In the previous article discussing Options Basics. we introduced options trading fundamentals and followed a sample Call contract trade. As a quick review, a Call option contract gives us the right to buy 100 shares of the underlying security and is a nice tool to place a speculative long trade with tightly defined risk while tying up a small amount of trading capital. Now let’s explore a Put  Option Contract. A Put is similar in structure to a Call, but is the right to sell  100 shares of the underlying security at a set strike price. Since a Put increases in value as the underlying drops in value it can be used as a vehicle to protect portfolio positions in case of a downturn as well as for a speculative short directional trade in a security.

CMG Case Study

Let’s take a look at using Puts to hedge and protect gains for your account. Imagine a scenario of making a purchase of Chipotle  (CMG) stock back in January 2011 on a nice bull flag setup. See the weekly chart below. CMG went on to make spectacular gains over the next year and in April 2012 it overthrew the upper channel line and spiked RSI to 80 signaling a potential overbought condition. CMG did indeed correct back to the 20 week moving average and by mid June showed signs of not being able to retake the 425 level and possibly creating a swing failure. During the week of June 29 th. CMG broke the support line and screamed warnings for us to get aggressive managing risk if we hadn’t done so already.

One strategy to manage CMG risk would be to sell off the position and pocket all the gains. However, given CMG corporate strength demonstrated by +20% income growth and no debt, we might want to hold onto some of the stock for the long haul appreciation. An ideal solution is to sell ½ of the shares to recover most of the original principal and use a portion of the profits to purchase a CMG Put option to lock in gains on the remainder. A protective put creates a loss protecting floor at the strike price minus the cost of the put. And when that breakeven is well above the initial cost of the shares you are in a fantastic no lose position. From a trading perspective, the most satisfying positions are when you can play with “house money.” The worst case scenario is still a very good profit and at the same time, the put allows unlimited gains if the stock continues to run higher you’d only be out the cost of the put premium.

Fast forward from June and we now know that CMG’s July earnings report slightly disappointed and the stock had a nasty drop while unprepared traders were scrambling for the exits. Let’s examine the results comparing an in the money 400 strike put with an at the money 380 strike put. From the previous article  we remember that in the money options have a higher delta which means they are more sensitive to changes in the stock price. They are more expensive, but also provide more protection. With 20/20 hindsight, the 400 strike put was the better choice given its floor level of $364 (400 strike – 36 premium) compared to the $355 (380 – 25) breakeven using the 380 strike put.