While the options market is viewed by some as a speculative arena full of degenerate gamblers, the truth is numerous investors utilize option contracts to reduce risk. Indeed, many head to the options market with the intent of acquiring protection and otherwise minimizing exposure to adverse moves in their stock positions.

With the first quarter of 2012 treating investors to a veritable profit-fest for many stocks, now may be an appropriate time to consider harnessing the power of options to lock-in gains and protect your hard-earned profits.

Given the versatility of option strategies, traders have a number of hedging alternatives at their disposal. Protective puts, collars, covered calls, and stock-replacement strategies all provide varying degrees of protection.

Let’s illustrate the protective put using the momentum darling and cult favorite Apple Inc. (NASDAQ: AAPL). Since the beginning of 2012 AAPL has risen at a torrid pace, capturing an impressive 53% gain for its shareholders. While some diehard fans may feel the run has just begun, others are thanking lady luck for their good fortune and more than happy to ring the register or at least take protective action.

One of the simpler hedging strategies available is the protective put, which consists of buying one put option for every 100 shares of stock you own. Think of the put as an insurance policy that locks in the right to sell your stock at the strike price. To contain the cost of the option, most traders buy a put residing out-of-the-money. With AAPL trading around $620, traders could purchase the May 595 put for around $19.75, or $1,975 per contract.

One way to view the effect of the protective put on your position is to look at things from a delta perspective. With a 100-share AAPL position, your delta is +100. This means as AAPL falls, you will be losing $100 per $1 drop. This rate of loss is reflected in the long stock risk graph included below.

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Since the May 595 put option has a delta of -35, it will lower your position delta from +100 to +65. Thus, you will only effectively lose $65 per one-dollar drop in AAPL instead of $100. In addition, the absolute value of the put’s delta will rise as it moves closer to the money. As the put delta increases from -35 to -50 to -75, this will further lower your overall position delta, causing you to lose money at a slower pace. This phenomenon is illustrated in the protective put risk graph included below.

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Traders can further modify the degree of protection by selecting a higher or lower-strike put option.  They can also increase or decrease the cost of the put by using a shorter- or longer- dated option.

If AAPL doesn’t end up pulling back at all, you have lost the cost of the long put (but of course youre gains in the stock holding have increased). For some traders, the peace of mind is worth the put premium paid.

At the time of this writing, Tyler Craig had no position in AAPL.