How to Use Protective Puts to Limit Losses
Most of us are constantly trying to minimize risk. We put on sunscreen to minimize the risk of developing skin cancer. We put on seat belts to minimize the risk of dying in a car crash. We buy insurance to minimize the risk that fire will destroy our home.
So, do you have insurance to minimize the risk your stock portfolio will plunge in value?
If you’re in the same boat as the majority of individual investors, the answer is “no.”
Everyone knows the market goes up and down. But for some reason, hardly anyone seems willing to spend money for protection against the inevitable market declines. It’s more fun to buy stocks and hope they go up.
The protective put gives you the best of both worlds. You can watch the price of your put increase while it offsets declines in stock prices. You’ve effectively minimized the risk of losing money. And you look incredibly smart in the process.
Protective Put Options
Most people are afraid of options. They assume they’re too complicated for regular people and can only be understood by professionals. It’s true that some options strategies are very complicated. But there are also strategies that any individual investor can easily implement. The protective put fits that description to the letter.
First, let’s review the basics of a Put Option.
A put option gives you, the owner, the right but not the obligation to sell 100 shares of a stock at a pre-determined price, called the strike price. No matter how far the stock price falls, you can still sell your stock at the strike price.
There are two other important features of the put option: 1) the time to expiration, and 2) the cost of the option, aka the option premium.
Just like buying insurance, you pay a premium to buy a protective put. And just like insurance, a protective put can save you money when things turn sour.
Here’s an example of how to use a protective put:
Let’s say you own 100 shares of Cisco Systems (Nasdaq: CSCO) you bought in April 2009 at $18. At that time, you expected Cisco to benefit from the rollout of global high-speed communications. Your analysis was correct, and by April 2010, the share price was up to $27.
When the price hit $27, you noticed the stock’s high in April 2008 was also $27, and you surmised that this price would be an important resistance level. Concerned that the price might pull back in the short term, you considered selling your position. But you didn’t really want to sell because you still liked Cisco’s prospects in the long-term.
Enter the protective put.
Your online broker said that for $1.60 per share, you could buy a put option on Cisco stock with a strike price of $27 that expires in October 2010. Buying this put option cost you $160 (options come in bundles of 100). In return, you bought the right to sell your Cisco shares for $27 until the option expires on the third Friday in October.
As you feared, your Cisco stock declined to $23.34 by June 21st. Your Cisco holdings lost $366. But your put option now trades at $3.70, for a gain of $210 (minus commissions). Instead of losing the whole $366, you’re only down $156.
If you believe that Cisco has farther to fall, or even that it won’t rebound to it’s high of $27 by October, you can continue to hold the put. If you still own the put option on October 15th, you can sell your Cisco shares for $27 even if the price is below $27. Or you can keep your Cisco shares, sell your option (as the date gets closer and closer to October 15th, the value of the option gets closer and closer to $27 minus the current stock price) and pocket the proceeds to offset your losses.
If the price of Cisco climbs above $27 before your protective put expires, you don’t have to sell your shares. Your option will expire worthless, and you’ll only lose the premium you originally paid.
Buying insurance via a protective put is one way to get some piece of mind. The protective put guards against a plunge in the price of your shares, but still allows you to enjoy upside benefits should the price of your shares continue to climb.
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