Protecting Your Profits with Options; Part I
We have covered the topic of put options as a hedge numerous times in the past, but it is always useful to remind you of the strategy and how it works.
U.S. markets are down over 30% and sinking in what has been a nasty bear market. So far, no clear bottom has yet to be established. Instead of watching your investment asset base erode, there are ways to protect your stocks or portfolio against major downside moves.
You may not be able to purchase direct insurance for your investment portfolio like you can with your home or valuables, but via the use of options, you can create a hedge to protect against potential capital losses. The fact is that investment assets are valuables, probably representing the largest or second largest value after your home. When it is time for you to retire, the value of your investment assets would be probably far in excess of your home value. So this makes protecting your investment assets that much more critical, so you can enjoy that retirement.
Hedges are done via put options. For those of you who are not familiar with basic options, an option is a binding contract established between the two participants on the opposite side of a trade (i.e. the buyer and seller). A purchaser of an option buys the right, but not the obligation, to either buy (a call option) or sell (a put option) the underlying instrument. A buyer of a call option is said to be bullish, while the opposite is true for the holder of a put option.
In this article, we are primarily interested in put options, as a strategy for protecting the value of a stock or a basket of stocks you may hold. You can establish put hedges for a single stock or a basket of stocks where buying put options to match each stock would be economically infeasible, as well as improbable due to the limited selection of put options. If you own a basket of stocks, look for a stock index option that has a high statistical correlation with your particular group of stocks.
Holders of technology stocks, for instance, could buy put options on the NASDAQ-100 Index — representing the 100 major technology stocks trading on NASDAQ. Just flash back and think about how handy these index put options would have been when the NASDAQ Composite was trading at over 5,132 in March 2000, just before its fall to the abyss.
The mechanics of buying put options on a stock index are quite straightforward and no different from put options on an underlying stock. There are only a few things to keep in mind. Remember that index options are cash settled and you must find an index option that best matches the group of stocks to protect. Once you find the
appropriate index option, the next step is matching the value of your investment portfolio as closely as possible with a corresponding number of put options that, when combined, approximates the value of your investment assets.
A portfolio manager may use put options as a short-term or long- erm hedge or as insurance against a downturn in a stock or market index.
As an investor, say you were long 1,000 shares of Microsoft Corporation (NASDAQ/MSFT), you could protect the position against any major weakness by purchasing 10 put option contracts (each contract represents 100 shares) in a hedging strategy termed a “Put Hedge.” This would allow you to protect against any short- erm decline in the stock, while retaining the upside potential.
The key elements you need to decide on are the month of expiry for the option and the strike price. If you are nervous longer-term, you may want to buy a put option with an expiry in excess of nine months out. The strike price is the price at which the option is executable. For instance, with Microsoft trading currently at $21.00 and near the 52-week low of $20.65, you could buy a put option with a $15.00 to $19.00 strike price. The decision is up to you and depends on your analysis.