Insure Your Portfolio Against Huge Losses

The stories are already beginning to trickle in. In the months to follow, the stream will no doubt become a flood: A couple whose retirement is in doubt because they had much of their portfolio in presumably solid, safe giants like Wachovia (NYSE: WB  ) or Fannie Mae (NYSE: FNM  ) . Parents who no longer have the college money they were saving for their 16-year-old, because they kept all of it in the market too long, instead of taking it out at least three years before they would need it. Retired sixtysomethings who may need to come out of retirement because they can't draw down their already depleted portfolios.

And that's not even including damage to shareholders of supposedly recession-proof stalwarts General Electric (NYSE: GE  ) , AT&T (NYSE: T  ) , and Pfizer (NYSE: PFE  ) , among many others.

It's twice as terrible to hear these stories, because they could have been prevented -- and much of the worry, stress, and loss sidestepped.

What lesson can we draw from the past year to help shield our portfolios from losses in the future? While almost nobody could have predicted the collapse of so many American institutions, from Lehman to AIG (NYSE: AIG  ) , there is at least one step we can take to protect ourselves against future unknowns when the stakes are high: Use options for insurance.

Options are tools, not weapons
Around Fooldom, options have typically been given the polite brush aside. "Most investors," the argument goes, "do not need to use options to succeed over a lifetime." Which is true. "And most investors will lose money on options." Which is not true, and not entirely the point, if you use options in the right ways.

For those unfamiliar, options are simply the right to buy or sell a stock at a set price by a specific date. Options were introduced to the public in 1973 by the Chicago Board Options Exchange. They've enjoyed increasing trading volume annually for years as people learn about their value.

I was skeptical of options for several years, too, until I started to learn more about them from Motley Fool articles written around 2000. The past eight years, and especially the past five, I've happily used options in managing real-money public portfolios, as well as in my own portfolio. They've helped me to obtain better buy and sell prices, to bet against some positions or hedge others, and to insure against possible declines.

Buying put options for insurance, especially when you have a lot riding on a few positions, can be as smart as having insurance to protect your house against fire.

How puts work
A put option gives its holder the right to sell a stock at a set price by a certain date. Buying a put option when you also own the stock is basically buying insurance for your stock, or hedging against a possible decline.

For instance, if you own 1,000 shares of Citigroup (NYSE: C  ) , currently trading around $23, you could buy 10 put option contracts (each contract represents 100 shares of stock) to insure your entire position against further decline.

Today, it would cost you about $3.75 per share to insure a $20 sell price (strike price) on your Citigroup shares all the way until mid-January 2010.

So, even if Citigroup fell to $0 during the next 15 months, the put option owner would be able to sell out at $20 – for a net sell price of $16.25 after accounting for the cost of the puts.

If Citigroup falls less far, and you still believe in its long-term potential, you can sell the puts for a profit and continue to own the shares.

On the other hand, if Citigroup is $35 per share a year from now, your $20 insurance policy won't have much value anymore. Still, you were protected on the downside for the past year, and you've profited with the stock as it increased.

There are also secondary benefits. The knowledge that your largest holding is insured may make you comfortable enough to nibble on newly beaten-down opportunities you see, or to keep holding the other, smaller positions you already own.

At the very least, with your key positions insured, you won't run for the hills and sell out at the very worst times. And when the markets recover, you'll participate.

When to use puts
It's not cheap to insure large positions for long periods of time, especially in today's environment. But in these times, that up-front cost can be dwarfed by the losses you might then avoid.

Generally, you should consider put options as insurance for positions that are large or vital in your portfolio, or that face more risk now than you originally presumed. Also, if you're preparing to sell a position in the next year or two, puts are a handy way to insure yourself a minimum sell price by your chosen sell date. You pay for the privilege, but from there it's all upside, with no worries about downside.

Use options to take advantage of your knowledge of a stock
I use options to leverage my existing knowledge of a stock's valuation and business model. Many lucrative option strategies exist for stock-based investors -- strategies that complement your stock portfolio, rather than compromise it. I'm not an options speculator or trader. I'm a stock-based investor who understands the power of options when used in conjunction with stock knowledge -- and when used for risk management.

We're going to use options in the Fool's new $1 million real-money portfolio, Motley Fool Pro. We'll be about 70% invested in long-term core stock holdings, 15% in ETFs, shorts and hedges, and 15% in options. We launch Oct. 7 with the goal of building a portfolio that can ultimately profit whatever the market throws our way. If you're interested in learning more about the new Motley Fool Pro portfolio, and sensible option strategies, just enter your email address in the box below.

Jeff Fischer doesn't own shares of any companies mentioned in this article. Pfizer is both an Income Investor and Inside Value recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (43)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 02, 2008, at 2:00 AM, nitsud21 wrote:

    Nice. Where can I go to get more information on puts and calls?

  • Report this Comment On October 02, 2008, at 10:37 AM, TMFFischer wrote:

    nitsud21: The Fool will have more information on options on a regular basis now, too, partly as we launch a new service (PRO) that uses them as part of a longer-term, stock-based strategy. Options can be used for protection -- as this articles writes about -- and for income, for better buy or sell prices, and as a safer ways to short things, too. So, watch the Fool for more info as well. I've been using options sensibly for years now. Best, Jeff

  • Report this Comment On October 02, 2008, at 1:08 PM, TMFFischer wrote:

    XMFHamp: I'm not making direct recommendations in such a general column like this (obviously). I'm just sharing basic examples that can then be extrapolated to fit one's own situation, with various stocks, so an investor can consider the possibilities of insurance where they might feel the need for it. It's surely clear to you and to any reader: a decision to buy puts depends on the real-life situation, not on the most generic example I could find for purposes of demonstration. But even in this situation, if one has fear that Citigroup is going to $10 (in today's environment, it could happen in a flash) the protection may prove worthwhile. As stated, insurance policies are very expensive right now (for obvious reasons), but buying them in the past on anything from Fannie to Lehman's, despite high prices, paid off. Would you always want to pay up? Obviously not. These are unusual times and they promise to go on for quite a while yet, I suspect, so if you want protection now, you do need to pay up (especially in financials). But ultimately, one's unique situation is all that matters in considering whether puts are worth buying or not in any instance. And that includes one's risk tolerance and goals, so the right answer will differ with each individual -- and with each stock. You probably know, or will learn with time (perhaps you're very young? congrats!), that investing is a nuanced process.

  • Report this Comment On October 02, 2008, at 1:49 PM, ellesummer wrote:

    I finally understand puts! Thank you for including an example and writing in such a straightforward way. I was under the impression that options were used only by people who wanted to make a lot of money very quickly or lose a lot of money very quickly (I know that there is a certain option that does this). This would help many people in this type of environment right now.

    I have a question though - what if the company you bought the put on was Lehman Brothers - would the contract still be honored?

  • Report this Comment On October 02, 2008, at 5:11 PM, TMFFischer wrote:

    ellesummer: happy to help! Thank you... And the answer is, yes, if a company goes to zero, like Lehman, you've just hit the jackpot with your puts. They'll have the full value of your strike price (say it was $35 per share) and you can sell the options for that value (same thing as selling all of your stock for that price).

  • Report this Comment On October 02, 2008, at 6:43 PM, aamire wrote:

    that educated me, thanx. Can people/ institutions taking your insurance default on their committment too?

    ignorant.

  • Report this Comment On October 03, 2008, at 7:36 PM, enet12001 wrote:

    I was sent an article from "The Motley Fool" titled "The ONE shock proof investment that just goes up." And "Just look at these gains last year from water technology companies..." The stocks and there last year gains that were listed in this article were as follows:

    CCC -- stock up 283%

    HDRX -- stock up 325%

    PNR -- stock up 528%

    WWAT -- stock up 630%

    I personally went back and check out these stocks via Bloomberg.com and none of them were even close to showing these gains, in fact HDRX closed the year as a loss.

    So what gives with these gentlemen and there newsletter? Would anyone from "The Motley Fool" please explain this to me?

    Thank you!

  • Report this Comment On October 04, 2008, at 12:46 PM, wjhern wrote:

    The CBOE Learning Center at http://www.cboe.com/LearnCenter/ has good info about options.

  • Report this Comment On October 05, 2008, at 12:04 AM, DanielBeatty wrote:

    Very Cool that you guys are now open to options. I hope you will be entertaining the idea of selling options as well as other option strategies.

    Right now you talked about protective puts buying them as an insurance policy, how about selling calls as an insurance policy that pays you to use it? Or making monthly income selling option spreads without ever owning stock?

    Like I said it is cool that you are going to have a small portion of the investment portfolio as options. I have been doing it for years.

  • Report this Comment On October 06, 2008, at 12:31 PM, TMFFischer wrote:

    Daniel -- Thank you... and indeed, we're going step by step into more option strategies. Today, in fact, we'll be running an article about selling calls on your positions to pay for your put insurance. (No cash out of pocket, and you're insured.)//// XMFHamp: Yup, the Amazon short is a perfect example of why buying puts, as a short (not as insurance in this case), is also a better strategy than naked shorting. Luckily, that short was at least partially hedged with long calls, so that helped, and then the next time around I just bought puts instead of naked shorting.

  • Report this Comment On November 26, 2008, at 10:54 AM, somacho wrote:

    why no reply to enet12001?

    Citigroup turns out to be a prescient example

    My wife and I reached a comfortable retirement level with a net $9,000,000 in 2001. We lost $5,000,000

    from 2001-2005 (no speculative stocks). We recouped $1,000,000 in 2006-7 and now have lost $1.8 in the last 10 weeks. Ninety per cent of our investments are TMF recommendations. Hard to see these performance numbers we cannot relate to just like enet 12001

  • Report this Comment On October 28, 2009, at 1:14 PM, dsk315 wrote:

    words like guarantee are not often used when talking about investments. however...

    The Options Clearing Corporation uses them

    http://www.optionsclearing.com/publications/occ_financial_gu...

    We use options to insure investments and generate income. learn more: www.definedriskstrategy.com

  • Report this Comment On March 15, 2010, at 11:55 PM, kenny1703 wrote:

    that educated me, thanks!

    http://www.commoditycalendar.com

  • Report this Comment On June 03, 2010, at 6:24 AM, sophie59 wrote:

    I really appreciate this article because this article provide us lots of information which are related to this topic and we want to know full information about this article.

    ==================

    <a href="http://bestbetinsurance.com" rel="dofollow">Insurance</a>

  • Report this Comment On June 03, 2010, at 6:25 AM, sophie59 wrote:

    i really appriciate this article because this article provide us lots of information which are related to this topic and we want to know ful information about this article.

    ============

    <a href="http://bestbetinsurance.com" rel="dofollow">Insurance</a>

  • Report this Comment On January 06, 2011, at 10:37 AM, prr42 wrote:

    Being new to options, i have allot of questions. looking for basic info. first I'm learning from your column. First I think puts run out at expiration date. I believe. second what about calls and covered calls, i think they can be canceled or bought out, by me, before the expiration date. Is this correct if so how. example would be great. thks

  • Report this Comment On December 05, 2011, at 2:18 PM, TacticalOptions wrote:

    Good article, protective puts can be a good tool for portfolio insurance.

    http://sellacalloption.com/2011/09/

  • Report this Comment On January 06, 2012, at 8:40 PM, vaderblue wrote:

    if you watch CNN after market those guys are really good on options. They will give you the play. Awesome.

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