1. Bearish speculation: meaning that the put buyer expects the stock price to go down, and hopes to profit by buying the stock after it declines and sell it by exercising the put at a higher price. For example, when the stock is $15.25, the speculator might buy the 15 Put. If the stock drops enough, the speculator can buy the stock and sell it at $15 for a nice profit by exercising the put. Or, more simply, he can just sell the put, which is now in the money and selling for much more than the put buyer paid.

2. Protection of a long stock position: the put partially protects the stock owner, since if the stock price drops below the put price, the owner can exercise the put and sell the stock at the put's strike price. For example, if you bought XYZ stock at $18, you might consider buying the 17.50 Put for $0.95 or the 15 Put for $0.15 in order to protect yourself. Let's look at both possibilities, assuming the stock drops to $12. If you bought the 17.50 Put, you still can sell the stock at $17.50 by exercising the put. Despite the drop in stock price, your loss is minimized to the $0.50 difference between the $17.50 you got by exercising the put and the $18 you paid for the stock, plus the put premium you paid. If you bought the 15 Put, you loss is higher, the difference between $18 and $15, plus the put premium. The two results would look like this:

The 15 Put was much cheaper to buy, but only protected against a catastrophic loss. The 17.50 Put cost more but conferred much greater protection. The closer to the stock price the put's strike price is (that is, the closer to the money the strike is), the more you are protected - but the more you will pay for the put. And vice versa. At this point, you might be thinking "okay, given the above example, why don't you buy protective puts?"

The above example ignores the flip side of protection. When you bought the 17.50 put for $0.95, you effectively increased your basis in the stock to $18.95, plus the trade cost of buying the put. You have to earn an additional $0.95 on the trade plus trade costs just to break even. Now assume that you sold the 20 Call for $0.75 to create a covered call. You're still in the hole $0.20 ($0.95 put - $0.75 call premium) on the trade, plus trade costs. What was the benefit of the protective put, exactly?

Let's use another example of an earlier trade we did on USG Corp. (USG), which was bought at $15.11, and the 15 Call was sold for a premium of $1.03:

Here is the result from running the trade:

Now lets compare the two possibilities (close position versus buying protective puts) if the stock drops below $12.50, assuming we exit the trade when the stock hits $12.50:

The improvement from buying the puts isn't very dramatic, only $0.20. And the above example assumes that we closed the position and only got $12.25/share. If we closed the trade at $12.50 or higher instead of $12.25, the put buy would not give even as good a result. Note that in the above example, we didn't show the stock buy at $15.11 and writing the call for a $1.03 premium - we just showed the trade's net debit ($15.11 - $1.03).

However, stock prices frequently yaw a good bit before expiration. For example, during the USG trade, it dropped almost to the breakeven point ($14.08) and then rallied to close at $14.87 by expiration. Then we called an exit after expiration and sold USG at $15.40. We preferred to put a stop limit order in on the trade to exit the trade if the stock hit $12.50. In view of the stop, aprotective put would have been no real help and would have drained call premium away. The $0.25 for the put may not sound like much, but if you only trade one call contract, it will more than pay the trading costs for the entire covered call trade! Too much for us! In short, protective puts work best for professional (institutional) traders whose trading costs are virtually nil.

You may be thinking, "gosh, there ought to be some way to create some protection." You're right, there is, and it's just common sense. Here are three good possibilities; pay especial attention to #3:

1) Buy a put two to four months out, intending to sell calls against the stock every month. The put premium will eat heavily into returns, but will give protection. If you find a stock with put premiums aligned just right, this strategy can work. It commits you to the stock while you own the put, however, and there is a risk that the implied volatility that creates good premium will cease, giving such small returns from writing calls that you never get the put premium back. We don't like this strategy, because you still are gambling - gambling that the stock will continue paying good call premiums for the life of the put.

2) Buy the 15 put, since it still leaves a profit from selling the call and at least protects against a catastrophic drop. This strategy may confer peace of mind, but we don't consider it a good strategy, since the cost usually makes it prohibitive.

3) Set a stop (stop limit order) on the trade, so that you automatically exit the trade when the stop is hit. The stop should be set at a logical price, such as just below the nearest support level. It is true that the stock can trade right through the stop, and the exit using our above XYZ example could be lower than $15. We don't buy puts, but use stops, since stocks seldom will trade through a stop. And if you can consistently call trades right, this is vastly more profitable than buying puts.

and now we'll sneak in a bonus alternative #4:

4) Sell deep-in-the-money covered calls! The premium you get not only provides a return immediately, but protects you against a price drop in the amount of the call premium received. So if you buy XYZ stock at $18 as in our above example and sell the 15 call for $3.60, you got a slightly smaller return than from selling the $20 call ($0.60 instead of $0.75), but you just protected yourself against a $3.60 drop, so you begin the trade with both a profit and a huge cushion. All covered calls put money in your jeans and give you a cushion against a drop in price, and deep-in-the-money calls give huge protection. (Now you know why we like covered calls so much.) If you're worried about the stock or the market, write deep!

So unless you're going to pay top dollar for a protective put not too far out of the money, it makes more sense to write covered calls and set a stop price just below the logical support level. The stop price will almost always be higher than the strike price of the put you would realistically buy because it is cheap enough to make economic sense - and give you even better protection than the put. In our above example, we set a stop on USG of $12.50 - $13, so buying the 12.50 put really would have been nonsensical. Sure, you could have some trades in a year where a put would have made a crucial difference, but buying a put on every trade would severely dampen profits.

Now, do protective puts make sense for you? Admittedly, they often make sense for professionals with miniscule trading costs who are protecting big long positions, but do they make sense for the covered call writer? If you have a good support level in the stock for setting a stop, and especially if you write a deep-in-the-money call, how much real protection does a "protective" put add? For us, it doesn't add up. Until next time...

Ways to Try CallWriter Try CallWriter for 10 days without risk - absolutely free! You'll have full access to our membership site! A $27.00 value Details Buy one month of CallWriter membership and get the second month free! $79.95 Save $79.95 Details Buy John's Ultimate Covered Call Book now and get two full months of CallWriter membership. $139.95 Save $119.90 Details Contribute an Article To contribute an article to the Money NewsLetter, send your contribution, along with your promotional byline, to: newsletter@callwriter.com. We don't pay contributors, but we will include your byline and a link to your website. Reproduction Don't hesitate to print out this newsletter for your own use or forward a copy of it to your friends and associates (we want you to), but please ask permission before reproducing the content in any form -- we would like to know who you are and how you are using it. Disclaimer We are not brokers, investment advisers or securities analysts and do not recommend the purchase, sale or holding of any security. Your use of any information or strategy appearing in this newsletter or on CallWriter.com is solely at your own risk. We urge our newsletter subscribers and CallWriter.com website members to do all requisite and analysis and properly plan each trade prior to making the trade and to manage each trade effectively. Covered call and other potential trades discussed in this newsletter or on CallWriter.com do not constitute trading recommendations by CallWriter or any other person and are presented by solely for informational and educational purposes.