In my recent article 5 Steps to Protect Your Portfolio, the final step I discussed was utilizing put options as insurance that any unrealized gains you have don’t turn into losses.
Most investors have heard of options but often think they are just for rich folks or hedge-fund managers, who employ them for speculative purposes. Certainly, sophisticated investors regularly use them as leverage to maximize their portfolio gains. But they also like to use options such as puts to nail down their gains and to mitigate losses should their stocks’ prices head in the wrong direction.
In essence, put options provide protection by betting that the underlying stock will decline. They give you the right (not the obligation) to sell the stock at a certain price at a specific future time.
There are three scenarios in which a put can help you protect your portfolio:
Protect Unrealized Profits
Let’s pretend you own 100 shares of Intel (NASDAQ:INTC), which closed yesterday at $26.71. The stock has had a nice run this year, up from its 52-week low of $19.16. If you had bought those shares at the low, you would be sitting on a gain of about 39% today — not too shabby for a very volatile market!
And while you might think the shares have more momentum in the short term (like I do), so you don’t want to sell them right now, you also know any whiff of trouble from Europe or other bad economic news could send the market — and Intel’s fortunes — downhill.
That’s when buying a protective put can help mitigate your potential loss.
First, you buy one put option from your broker, which gives you the right to sell 100 shares of INTC.
If you are very risk-averse and decide you want to protect your current gain, you can buy a put option that allows you to sell INTC at a price of $26 through July 20, 2012. (Note: There are many options available, depending on your time frame. Read more about Intel’s options here.)
As of Jan. 24, this particular put will cost you about $202, plus commission. If the price of INTC continues climbing, you will be out the $202 you paid for the option, but you will reap the benefit of the price increase in your INTC shares. But if the price of INTC stock declines under $26, you can still sell it at that price, through July 20. Bottom line: You have locked in your gain!