The recent selloff in stocks should have made you think hard about how to protect your portfolio assets against major losses. Without a risk management strategy, you leave your assets vulnerable to losses and reduce your wealth potential.
It is true that the markets have rebounded, but take this as an opportunity to learn about employing a simple risk management tool using options.
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, let’s take a look at mega search engine Google (NASDAQ/GOOG).
Imagine you were fortunate enough to have picked up Google shares 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 (as each contract represents 100 shares) in a hedging strategy called 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 $465 or thereabouts, you could purchase one January 2008 “in-the-money” put set to expire on January 18, 2007 with a strike price of $470. The total premium or cost paid is $41.20 per share or $4,120 per contract.
If Google plummets to your entry price of $300 at the time of expiry, you can either retain your long position and realize your profit on the puts, or, alternatively, sell the 100 shares of Google for the $470 strike price, despite the fact the stock is trading at $300.
The put option acted as insurance. You would walk away with $12,880 ($470-$300 x 100 shares less the $4,120 premium) in profits under this scenario.
The risk with a put hedge is that if Google moves up, you could lose the entire premium you paid ($4,120). But when a stock is appreciating rapidly, it is a small price to pay to know you are protected. Another way you can look at it is, would you drive without having insurance on your car?