Stocks continue to show bullish buying at this time as the DOW broke above 13,400 on May 9 while the NASDAQ is eyeing 2,600. You may want to ride the momentum as long as possible. 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? How about establishing a put hedge as a short-term or long-term hedge or insurance against a downturn in a stock or market index.
To demonstrate this, take a look at online merchant Amazon.com Inc. (NASDAQ/AMZN), which recently surged over 25% on strong earnings.
Say you are fortunate enough to have bought Amazon.com at a lower price, say $40.00. Let’s assume you were long 100 shares of Amazon.com; you could protect against any weakness by purchasing one put option contract (each contract represents 100 shares) in 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 Amazon.com shares trading at $61.36, you could purchase one October 2007 “in-the-money” put set to expire on October 19, 2007 with a strike of $65.00 at $7.20 per share. The total premium or cost paid is $720.00 per contract.
If Amazon.com plummets to your entry price of $40.00 at the expiry, you can either retain your long position and realize profit on the puts, or, alternatively, sell the 100 shares of Amazon.com for the $65.00 strike price despite the fact the stock is trading at $40.00.
The put option acted as insurance. You would walk away with $1,780.00 (($65.00-$40.00) x 100 shares less $720.00 premium) in profits under this scenario.
The risk with a put hedge is that if Amazon.com should move up, you could lose the entire premium. But when a stock has appreciated rapidly, as was the case with Amazon.com, 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?