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Insure Your Portfolio Against Huge Losses

The stories of woe continue to trickle in. In time, the stream will no doubt become a flood: A couple whose retirement is in doubt because they had too much of their portfolio in presumably solid, safe American institutions such as Bank of America (NYSE: BAC  ) , Ford (NYSE: F  ) , or General Electric (NYSE: GE  ) . 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 instead of taking it out at least three years before they would need it. Sixty-somethings who 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 the most popular and most dynamic growth companies, including the likes of Cisco (Nasdaq: CSCO  ) , VMware (NYSE: VMW  ) , and NVIDIA (Nasdaq: NVDA  ) , among many others.

It's twice as difficult to hear these stories of loss 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? There is at least one easy step investors can take to protect 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-off. "Most investors," the argument goes, "do not need to use options to succeed over a lifetime." Which is true. "And most investors lose money on options." Which is not true when you use options in the right ways.

For those unfamiliar, options give the option owner the right to buy or sell an underlying 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 as people learn of their value as portfolio tools.

I was skeptical of options for several years until I started to learn more about them from Motley Fool articles written around the turn of the millennium. Over the past eight years, and especially the past five, I've happily used options in managing real-money public portfolios, as well as my own portfolio. They've helped me obtain better buy and sell prices on strong companies, bet against some positions, or hedge others -- which can smooth out returns -- and ensure against possible market declines.

Buying put options for insurance on your stocks, especially when you have much of your savings parked in your portfolio, can be as smart as having insurance to protect your house against fire.

How puts work
A put option gives its owner 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 like buying insurance, or hedging against a possible decline, because the put option guarantees you a set sell price on that stock, if you want it, at a later date.

For instance, if you own 500 shares of Home Depot (NYSE: HD  ) , currently trading at about $24, you could buy five put-option contracts (each contract represents 100 shares of stock) to insure your entire position against further decline should consumer spending remain depressed. If you're particularly concerned about the second half of 2009, you might buy put options that don't expire until January 2010.

Today, it would cost you about $3.60 per share to insure a $25 sell price (strike price) on your Home Depot shares until mid-January 2010 -- or $360 per 100-share contract.

So, even if Home Depot declined to $10 during the next seven months, the put option owner would be able to sell out at $25 – for a net sell price of $21.40 per share after accounting for the cost of the puts. The roughly 15% premium is rather expensive, but that's largely due to today's volatile market climate.

If Home Depot declines in the next few months, and you still believe in its long-term potential, you can sell your puts for a profit (the put prices vary daily, just like stock prices) and continue to own the shares.

On the other hand, if Home Depot is $25 or higher by January (say it's $35), your $25 insurance policy won't have any value anymore. Like any insurance policy, it expires. Still, you were protected on the downside for the potentially turbulent second half of 2009, and you still profited with the stock as it increased.

There are also secondary benefits. The knowledge that your key stocks are insured with puts may make you comfortable enough to nibble on newly beaten-down opportunities that you see. At the very least, with 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 volatile environment. But in these times, that up-front cost can be dwarfed by the losses you might later 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 the underlying business. Many lucrative option strategies exist for stock-based investors -- strategies that complement and enhance 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 and to improve returns in up, down, or flat markets.

Along with core stock holdings, we're using various option strategies in the Fool's $1 million real-money portfolio, Motley Fool Pro. If you're interested in learning more about Motley Fool Pro and sensible option strategies, just enter your email address in the box below.

This article was originally published on Oct. 1, 2008. It has been updated.

Jeff Fischer doesn’t own shares of any companies mentioned in this article. Home Depot is an Inside Value recommendation. VMware is a Rule Breakers recommendation. NVDIA is a Stock Advisor selection. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (10)

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 June 05, 2009, at 5:59 PM, marhu wrote:

    Similarly, selling "insurance" (puts) is a very profitable way to make money if you understand how to calculate the risk/reward ratio. As this article mentions, the premiums are higher during periods of market volatility.

  • Report this Comment On June 06, 2009, at 8:12 PM, TMFFischer wrote:

    Marhu - I couldn't agree more. Selling puts is one of my favorite strategies for income and better buy prices, so we use it often in Pro. Thank you for your comment! Jeff

  • Report this Comment On July 18, 2009, at 7:17 PM, UltraContrarian wrote:

    And most investors lose money on options. - Which is not true when you use options in the right ways.

    Some data to back up your claim would be nice.

  • Report this Comment On July 18, 2009, at 7:31 PM, alexreising wrote:

    BTW, that Home Depot example would be a horrible maneuver in real life because of the premium. Home Depot is actually a company that I would suggest selling calls on as it probably doesn't have a huge upside after last weeks enormous run. Sell an August call and bank the premium. if it goes back down, you're hedged the amount of the premium and you can sell a call or a put on it for the next month depending on your opinion of where the price will head.

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