Investing in Options: An Insurance Policy Against a Volatile Market
by Jason Jenkins, Investment U Research
Monday, January 23, 2012
During the current market environment a good number of investors who lost money did so because they failed to keep the profits they attained or cut their losses. What they needed were strategies that could effectively help provide a means for exiting an equity position or offsetting losses when your stock moves against you.
One technique that Investment U recommends is using a trailing stop. Trailing stops are simply a stop-loss order set a certain percentage below the value of the stock - and then adjusted as the price rises. Whenever a stock in our portfolio pulls back 25% from its closing high - or from our original entry point - we sell the stock at market. This strategy keeps us from selling our stocks while they're in a major uptrend - and prevents small losses from becoming unacceptable losses.
But this isn’t the only strategy available to us to protect against losses in a volatile market.
A Stock Insurance Policy
If you hold a stock that might take some losses in the short term, but your heart and valuations tell you that this is something you should be long on, a protective put may also provide short-term protection against all the current volatility we’ve been facing.
A put option gives its owner the right, but not the obligation, to sell 100 shares (options work in lots of 100) of the underlying asset (in this case, shares of stock) at a definite price known as the strike price until a specified expiration date. No matter how low the stock price falls, you still can sell the stock for the strike price until the option expires.
When an investor also owns the common stock and a put option on that same stock, the position has limited downside risk during the life of the put.
Here’s an example:
Assume you own 1,000 shares of stock ABC worth about $72,000. If you do nothing and the stock suddenly drops to $50 a share, you could lose $22,000.
To help reduce this risk, you can buy "insurance" on your stock. If you decided to buy 10 put options with a strike price of $70, at a price of $2 (total cost $2,000), you could exercise your puts at any time prior to the expiration and sell your stock at $70, 20 points above the current market price, or sell the puts themselves to offset most of the loss on your stock.
If you chose to sell your stock at $70 by exercising your puts, the premium you paid for your put options ($2,000) would be your "insurance premium," and the 2 points you would lose on your stock (because you paid $72 for it, and only sold it for $70) would be your "deductible." Overall, your loss would be about $4,000 to $2,000 on the stock and $2,000 in premium (the amount you paid for the puts).
If your stock stayed above $70 by the expiration date, your puts would expire worthless, and the $2,000 you paid for the puts would be lost - just like the insurance premium you paid on your car if you didn’t have any accidents.
Options Provide More Options
To determine whether buying protective puts makes sense or not, consider how low you think the stock might drop. Keep in mind that there are different protective puts on the market to buy depending on the strike price and the expiration date.
If the stock price drops, you can hold the put until you decide to either sell the put for a profit or exercise the sale of the shares. If you believe in the company and the stock price drops below the strike price of the put, you can sell the put and use the profits to buy more shares of the stock at a lower price – the put is its own investment vehicle thereby providing a great deal of flexibility.