Using Protective Puts: A Practical Example

I have been concerned that the precious metals market, especially silver, has been getting a little overbought seeing as the price of silver has gone up about 20% in the last month.  I am exposed to the price of silver through my retirement account investment in Silver Wheaton (SLW).  In fact, about 20% of my retirement funds are in the stock and since SLW had increased about 37% during this same period of time, I wanted to take some money off the table and collect some profits. 

Well, there are two different approaches to taking profits when a stock has made a big run like Silver Wheaton has.  First, the investor could simply sell his/her stake in the stock.  There are a few advantages and disadvantages to this approach.  First, the profit is guaranteed and there is no further risk involved in continuing to own the stock.  Now the investor can sleep well and not worry about a position that seems to have run too far, too fast.  Unfortunately, there is now no possibility of participating in any additional upside.  Even though a stock has increased 37% in one month, it could easily go up another 50% in the next month.  There is just no way to accurately predict with 100% confidence where the top will be.

The other approach to selling a stock involves the use of options.  In the case of my SLW investment, I chose to sell some shares at $36.99 on Tuesday of this week.  I also had purchased the previous day, November 35 put options.  This meant that I was absolutely guaranteed to sell the stock at $35 per share no matter what happens between now and next Friday.  I could sleep easily for the next two weeks knowing that my profit was locked in.  My basis in the stock is $28.86 so a profit of just over $6 per share is not insignificant.  I would hate to lose that knowing how volatile the silver market can be.

It turns out that purchasing those puts was the right call since the next day when I sold some of the shares at $36.99, the Chicago Mercantile Exchange raised the margin requirements for investors trading silver futures.  This was meant to take some of the speculation out of the market resulting in a sudden drop in the price of gold and silver.  My stock in Silver Wheaton proceeded to drop from roughly $37 per share to $32 by the end of the day.  Needless to say, had I not had the assurance of the put options protecting my investment, I might have panicked and sold.  Well, the next day the stock rebounded and this morning before the market opens, SLW is trading over $35 again.

I can't imagine getting whipsawed like that if I simply held the stock by itself.  By holding the puts, I have the opportunity to sit back and relax waiting for the dust to clear before making any important decisions.  I don't need to rush and trade on emotion.  I actually have more November puts than I do shares in SLW.  That is because as the stock increased, I ended up buying more puts to protect profits.  I have no problem spending a little bit of money for insurance to protect those shares knowing that at any moment, those profits could evaporate.

The plan now is to let the stock ride for the next 7 trading days until option expiration.  I have also sold covered calls on the stock and will be selling most of my shares in SLW.  These covered calls on a stock coupled with the protective puts creates an equity collar trade.  The nice thing about selling covered calls is that it allows me to pay for the cost of the puts.  It does limit the upside potential and forces me to at times sell at less than the current price of the stock.  But I usually don't allow it to get too far away before I will roll up the calls.  The nice thing is that I will be able to sit back and reassess what is happening in the silver market and get back in as I see fit in bits and pieces.

I don't want you to think I am bragging, but I would like to point out that protective puts can't help but be the right call when a stock has gained quite a bit in a short period of time.  There is no way to gain every last penny of profit since no one could possibly buy at the exact bottom and sell at the precise top of the market.  So, when the opportunity to lock in 20%+ profits, you should take it.