Stocks are currently showing some buying at this time as the DOW broke above 11,300 while the NASDAQ is eying 2200. You may want to ride the momentum as long as possible, but on the other hand, you also want some security. Should the market reverse, it could mean an impact on your portfolio.
So what do you do? What about establishing a put hedge as a short-term or long-term hedge or as insurance against a downturn in a stock or market index?
To demonstrate this, take a look at mega search engine Google (NASDAQ/GOOG).
Say you are fortunate enough to have bought Google at a much lower price, say $300. Let’s assume you were long 100 shares of Google, you could protect against any weakness by purchasing one put option contract (each contract represents 100 shares) in a hedging strategy termed a “Put Hedge.” This would allow you to protect against any short-term decline in the stock, while retaining the upside potential.
Case in point: With the price of Google shares trading at $381.49 (August 18, 2006), you could purchase one December 2006 “in- the-money” put set to expire on December 15, 2006 with a strike price of $390. The total premium or cost paid is $27.20 per share or $2,720 per contract.
If Google plummets to your entry price of $300 at the expiry, you can either retain your long position and realize profit on the puts, or alternatively, sell the 100 shares of Google for the $390 strike price despite the fact the stock is trading at $300.
The put option acted as insurance. You would walk away with $6,280 ($390-$300 x 100 shares less $2,720 premium) in profits under this scenario.
The risk with a put hedge is that if Google should move up, you could lose the entire premium. But when a stock is appreciating rapidly, it is a small cost to know you are protected. Another way you can look at it is, would you drive without having insurance on your car?