How to Protect Against Selling with Options
Thursday, March 17th, 2011
By George Leong, B.Comm. for Profit Confidential
Listen up, folks; stock markets have had a great run. There may be more upside moves ahead of us, as the economy continues to improve, but this is not a time to be aggressive given the turmoil in the Middle East and higher oil prices. You have made some nice gains and my investment advice to you is to take some profits off the table.
At this juncture, stock markets are pausing and showing some uncertainty. And, while I do not pretend to have a crystal ball, I do firmly believe in adopting strong risk management to protect your investments and hard-earned capital. This is my best stock market advice.
The last thing you want is to watch your gains disappear.
One of my favorite strategies to protect investment gains is the use of put options as a defensive hedge against market weakness. This strategy is called a protective hedge. Don’t be scared by the name or the fact that it employs derivatives, as the strategy is straightforward.
Under this scenario, investors may be somewhat bearish or uncertain and want to protect the current gains against a downside move in the stock or the market with the use of index put options.
For those of you not familiar with options, a buyer of a put option contract buys the right, but not the obligation, to sell a specific number of the underlying instrument at the strike or exercise price for a specified length of time until the expiry date of the contract. After the expiry date, the particular option expires worthless and any responsibility is eliminated.
The buyer of the put option pays a premium to the writer of the option, who gets compensated for assuming the risk of exercise. The writer of the put option is obligated to buy the stock from the holder of the put should it be exercised by the expiry date.
For the writer of the put option, the amount of premium received for assuming the risk is generally directly correlated to the volatility of the stock and market. The more volatile the stock, the higher the premium paid for the option. And low volatility translates into lower premiums.
You can buy puts for stocks and sectors. If your portfolio is heavy in technology, you can buy puts on the NASDAQ. Or let’s say you have benefited from the run-up in gold and silver to record historical highs; then a strategy may be to buy put options on The Philadelphia Gold & Silver Index, which tracks 10 major gold and silver stocks.
If you are heavily weighted in technology, you can buy put options in PowerShares ETFs (NASDAQA/QQQQ), a heavily traded put used for defensive purposes.
It’s that easy. Just take a look at the various indices that closely reflect your holdings or put options on individual stocks that you may have a large position in.
In this market, safety is the key.
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Tags: economic news, investment advice, market sector, protective hedge, put options, risk management, Stock Market Advice
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George is a Senior Editor at Lombardi Financial, and has been involved in analyzing the stock markets for two decades where he employs both fundamental and technical analysis. His overall market timing and trading knowledge is extensive in the areas of small-cap research and option trading. George is the editor of several of Lombardi’s popular financial newsletters, including The China Letter, Special Situations, and Obscene Profits, among others. His trading advice on stocks and options is also found on his daily trading site, Daily Profits. He has written technical and fundamental columns for numerous stock market news web sites, and he is the author of Quick Wealth Options Strategy and Mastering 7 Proven Options Strategies. Prior to starting with Lombardi Financial, George was employed as a financial analyst with Globe Information Services.
