Stocks are currently riding a nice upward crest in the market. You may want to ride the momentum as long as possible, but, on the other hand, you likely want some sense of security. Should the market reverse, it could mean a dramatic impact on your portfolio.
So, what do you do? How about establishing a put hedge as short- or long-term insurance against a downturn in a stock or market index.
To demonstrate this, take a look at mega search engine Google (NASDAQ/GOOG), which has exploded from its $100 IPO price to $425 last week in just over a year. That’s momentum!
Let’s assume you were fortunate enough to have bought Google at a much lower price, say $300. Let’s also 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 around $424.24, you could purchase one January 2006 “in-the-money” put set to expire on January 20, 2006 with a strike price of $430. The total premium or cost paid is $24.80 per share or $2,480 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 $430 strike price, in spite of the fact that the stock is trading at $300. The put option acted as insurance. You would walk away with $10,520 (($430-$300) x 100 shares, less your $2,480 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 this: Would you drive your car without having insurance?