Cheap (or Free!) Protection for Your Stocks

Recently, 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, 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 Yahoo! (Nasdaq: YHOO  ) as a general example. Suppose you own 500 shares of the $17 stock, and you want to protect it against further big declines. As of this writing, Yahoo!’s January 2010 put options with a $14 strike price (the price at which you could sell your stock, guaranteed) cost $0.92 per share.

So it will cost you $460 to insure your $8,500 Yahoo! position from now through January 2010, when these options expire. It's expensive, but the insurance would be great to have if Yahoo! falls to $11, as it did in March. No matter what happens, you'll be able to sell your shares at $14 -- but it's a net sell price of $13.08 after factoring in what you paid for the put options.

"But wait," you're saying, "I have to pony up $460 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 much of your insurance 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 500 shares of Yahoo!, you could write -- meaning sell -- five call options (each option contract represents 100 shares) on your stock for an immediate payment.

Yahoo!’s $20 January 2010 call options are paying $1.27 per share. You could sell call option contracts on your 500 shares, be paid $635, and then use the money to buy your $14 put contracts for $460. In this case, you actually end up $175 ahead, with cash in your pocket from the call options, while buying puts for insurance.

The catch, however, is that your upside is now limited. If Yahoo! increases above $20 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 $20 per share. So, even if Yahoo! recovers to $25 or higher, as long as you have these open call options, you'd be forced to sell at $20.

With this strategy, you're insured against a disaster, but you also have limited upside. Therefore, you use this strategy when you're on the defensive, concerned about protecting yourself from potential losses, and don't see tremendous upside in the near term.

When to insure positions with call option income
This 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 that you're "collaring" -- in this case, Yahoo!. You'll be able to sell it at $14, 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 Bank of America (NYSE: BAC  ) .

But the strategy can also come in handy with stocks that are volatile at the best of times, especially after making big runs, like to protect a position in Google (Nasdaq: GOOG  ) , Apple (Nasdaq: AAPL  ) , or Baidu (Nasdaq: BIDU  ) .

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, 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 or only a little out-of-pocket expense." The strategy is called a "costless collar."

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, and to get better buy or sell prices on your stocks.

Want to learn more? We're launching a video series designed to get you up to speed on options basics. Just enter your email in the box below for access -- it's completely free.

This article was originally published Oct. 6, 2008 under the headline "Free Protection for Your Stocks." It has been updated.

Jeff Fischer owns shares of Google, but no other companies mentioned in this article. Google and Baidu are Motley Fool Rule Breakers picks. Apple is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.

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