On Wednesday, I wrote about a way to insure your portfolio against decline by buying put options -- in effect, insurance policies -- for your largest or most important holdings. Options typically get a bad rap as being risky or speculative, but, used correctly to complement a long-term stock portfolio, they're simply tools to help you manage your risk and returns.
So, if you want to protect a stock you own, you can buy a put option. But in today's volatile market it will cost you even more than usual -- about $3,000 to $4,000 to insure the typical $20,000 stock position from now through January 2010. That may be worth it if your stock falls sharply or fails, but it's a lot of money to forfeit if your stock holds steady or increases in price.
There is a way, however, to insure a stock against decline without needing to spend much or any capital yourself. Now that's worth knowing about.
Buying protective puts with call option income (What!? We'll explain)
Let's use Citigroup (NYSE: C ) as a general example. Suppose you own 1,000 shares of the $16.50 stock, and you want to protect it against further big declines. Right now, Citigroup's January 2010 put options with a $15 strike price (the price at which you could sell your stock, guaranteed) cost $4.09 per share.
So, it will cost you $4,090 to insure your $16,500 Citigroup position from now through January 2010, when these options expire. The insurance would be great to have if Citigroup sits at $7 15 months from now. No matter what happens to Citigroup by then, you'll be able to sell your shares at $15 -- but it's a net sell price of $10.91 after factoring in what you paid for the put options.
"But wait," you're saying, "I have to pony up $4,000 just to insure what is supposed to be an investment? I know times are risky right now, with a lot of uncertainty, but that's a lot to pay for something that very well might not happen!"
It is. And there's an alternative.
Cash in pocket, insurance in hand
Instead, you could pay for your insurance entirely, and have money left over, by using the proceeds from writing call options on the stock. When you write options, you're the seller of the contract, rather than the buyer, so you're paid up front when you execute the trade. In this case, as the owner of 1,000 shares of Citigroup, you could write -- or sell -- 10 call options (each option contract represents 100 shares) on your stock for an immediate payment.
Right now, in fact, Citigroup's $17.50 call options are paying $4.40 per share. You could sell call option contracts on your 1,000 shares, be paid $4,400, and then use the money to buy your $15 put contracts for $4,090. You clear a little money even after commissions, and now your position is insured. No matter what Citigroup does, you can sell at $15.
And, in this case, since you paid net zero for this trade (you were in fact paid a bit), $15 plus some change is indeed your actual sell price should you end up selling, rather than the $10.91 that was your net sell price when you paid for your insurance out of pocket.
The catch, however, is that your upside is now very limited. If Citigroup increases above $17.50 per share and you keep your call options open to expiration, your stock would be called away from you -- in other words, it would be sold for you, at $17.50 per share. So, even if Citigroup recovers to $25 or higher, as long as you have these open call options, you'd be forced to sell at $17.50.
With this strategy, you're insured against a disaster, but you also have limited upside.
When to insure positions with call option income
The option strategy of buying a put and selling a call (or vice versa) is called a "collar" strategy. You're limiting the potential pricing outcome for the position you're "collaring" -- in this case, Citigroup. You'll be able to sell it at $17.50 or $15, no matter what.
A collar is a useful tool in bear markets or when you are uncertain about a business. This year, that would have applied to just about any company related to financials, from General Electric (NYSE: GE ) to AIG (NYSE: AIG ) to Morgan Stanley (NYSE: MS ) .
But the strategy can also come in handy with stocks that are volatile at the best of times, especially after making big runs, such as to protect a position in Google (Nasdaq: GOOG ) or Baidu (Nasdaq: BIDU ) . A collar strategy might also have made sense when Apple (Nasdaq: AAPL ) rebounded to $180 a few months ago, if you were concerned about it falling back.
The strategy may be used when you don't want to sell a stock quite yet, but you also want to limit your potential losses. With a collar, you limit your upside significantly, but you're also in effect saying, "I don't believe there's much upside in the near term anyway. Meanwhile, I'm concerned about the risk. So, I'll insure my stock without any out-of-pocket expense." In our example, it's called a "costless collar."
Collars can smooth returns and help you ride out a very rough market -- both of which help you survive to see a better day. They're not for everyday use -- no option strategy is a blanket strategy -- but they're useful for situations that merit protection.
Don't go into a collar hoping for the perfect outcome, however -- they're useful precisely because nobody can time the market or what a stock will do next.
Options as tools
Options are tools best used in tandem with in-depth business knowledge and a long-term stock perspective. They can be used to protect positions, generate income, short, or hedge with much less risk than naked short-selling, and to get better buy or sell prices on your stocks.
We're going to use options in the Fool's new $1 million real-money portfolio, Motley Fool Pro. By the time we're fully invested, we'll be about 70% in long-term core stock holdings; 15% in exchange-traded funds, shorts, and hedges; and 15% in options. We launch tomorrow (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.