If you want to protect the stock you buy on an exchange in New York, you need to go to Chicago. The Windy City will offer you a chance to insure your portfolio from losses with a financial product called an option contract.
What Are Options
Options are derivatives -- that is, they derive their value from something else. Options -- bought and sold at the Chicago Board Options Exchange -- can be traded on a stock, an equity index or a commodity. They afford their owners the right to buy or sell an asset for a set price during a pre-determined time period.
The options contract that locks in your selling price is known as a put option. Buying this contract gives the holder the right -- the 'option' -- to sell the security for that price during the contract's lifetime. On the other hand, a call option gives the holder the right to buy a security at a specified price within a specific time period. Options are priced per share and sold in standardized lots that cover 100 shares.
How Options Work
That's the theory. Let's see how it works in practice.
You buy shares of a large national bank for $25 after they have already lost half their value. While this seems like a steal and a great long-term move, you know that the banking sector is troubled. You've allocated this trade to the high-risk section of your portfolio, and you're willing to hold on through some volatility. Even so, you'd feel more comfortable if you knew you had a floor under the shares -- just in case.
You decide to buy a 17.50 put for 55 cents a share, which amounts to $55.00 to protect your 100-share position. This put option is cheap because it is 'out of the money,' which is the insider term for a put whose strike price is lower than the current market price. It's out of the money because the option isn't worth anything -- why sell your shares at 17.50 when the market price is 25?
But things change. Let's say that a dark cloud descends on banks and more bad news transpires in the sector. Your shares are hammered -- they drop to 12.50, half the price you paid for them. But instead of eating a 50% loss, you exercise your option and sell your shares for 17.50 -- five dollars more than the market price. That's still a loss (-30%) but it's less than it otherwise would have been. Plus you had the benefit of knowing that your losses were limited. Everyone else holding the stock without options protection bears the full risk of additional losses, up to and including a bankruptcy filing that would wipe shareholders out.
But how about this: Say you still have confidence in the bank. Well, your put option is now worth something -- at least five dollars of intrinsic value and more to account for the time left in the contract, in which the stock price could go lower and the option's price could rise. If you planned to hold the shares, you could sell the option at a profit and use the proceeds to either buy a few more shares or to lower your cost basis for the ones you already have.
For the buyer of a put option, the contract is an insurance policy -- a way to set the maximum level of losses in advance. The cost is limited to what she pays for the option, which is called a premium. This investor isn't taking a speculative position, she is simply taking prudent action to protect against the possibility of losses.
The seller, or 'writer' of this put option is bullish on the underlying stock. His bet is that the price is going to rise or stay the same. His goal is to generate income by collecting premium income. His risk, however, can be significant: If the option is exercised, he eats the difference between the stock's pre-determined strike price and the market price, which could theoretically fall to zero.
Though trading options is best suited for more experienced investors. Using a put option to protect against losses could be a prudent move for an investor.