Strategies to Minimize Major Downside Risk

Given the recent turmoil in stocks, investors have been facing a climate of volatile trading, as key market indices retested recent lows on Tuesday. So, it is time again to review ways of minimizing major downside risk.

By using options, you can create a protective hedge against potential capital losses. It makes sense to me and should to you. The fact is that investment assets are valuables, probably having the first or second largest value after your home. By the time you 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.

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 the NASDAQ.

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 you want to protect. Once you find the appropriate index option, the next step is matching as close as possible the value of your investment portfolio with a corresponding number of put options that, when combined, approximate the value of your investment assets.

A portfolio manager may use put options as a short-term or long- term hedge or insurance against a downturn in a stock or market index. For instance, let’s say you own 1,000 shares of Microsoft Corporation (NASDAQ/MSFT). You could protect this holding against any 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-term decline in the stock, while retaining the upside potential.

Example: Let’s say Microsoft shares are trading at $25.44 and you believe markets may not stabilize until after the first quarter of 2009, you can purchase 10 slightly “out-of-the-money” puts set to expire on April 17, 2009, with a strike price of $25.00. The total premium or cost paid is $2.25 per share or $225.00 per contract. If Microsoft falls to $20.00, you can either retain this long position and counter the paper loss with the profit on the puts or sell the 100 shares of Microsoft for the $25.00 strike price. If you keep the position and offset the puts, the profit from the protective put before commission would be $2,750 ($25.00-$20.00 x 1,000 shares, less the $2,250 premium paid). This would help offset the $5,440 decline in the paper value of the shares. The risk, of course, is that if the stock should move up, you would lose the entire premium when the option expires on April 17. Therefore, this is the risk you take for downside protection.