How to Protect Your Gains Against a Potential Correction

By George Leong, CFP, MBA — The Leong Side of the MarketcolumnWith the first quarter finished, we are getting set for earnings, which will be quite important given the gains we have seen. While the upside bias remains intact, you also need to be careful to protect your gains against a possible correction, as we have not had a notable one in quite some time. With housing and jobs continuing to be issues, there is a possibility of an economic relapse.
To help protect against this, I like using “put options.” Under this scenario, investors are bearish or unsure and want to protect against a downside move in the stock or the market with the use of index put options. Put options are also used as a method by the writer of a put option to set a lower price at which to buy the stock.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.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 heavily in technology, you can buy puts on the NASDAQ. Or let’s say you believed gold and silver stocks are overvalued due to the run-up. In this scenario, you could buy put options on the Philadelphia Gold & Silver Index, which tracks 10 major gold and silver stocks.

Similar to call options, put options can also be used in special trading situations. For example, when there might be speculation that a company is set to report poor results, or perhaps rumors of some accounting irregularities or corporate mismanagement, stocks that experience a rapid decline in their price benefit holders of put options.

Put options give the trader major leverage to make potentially good returns and act as a hedge against downside moves.

You would not avoid buying insurance for your home or expensive assets, so why not buy put options as insurance against market weakness? It’s simple and makes a whole lot of sense.