Use Options to Protect, Hedge, and Gain

Let's debunk their boom-or-bust reputation. Options can actually be helpful tools to:

  1. Protect the value of your portfolio.
  2. Invest while putting much less capital at risk.
  3. Earn strong returns in a volatile market whether or not the indexes end up going anywhere.

Hedge or protect your positions
Enjoyed the market run-up since March 2009, but growing concerned heading into the second-half of 2010 as stocks have appreciated dramatically? Buying put options -- which "pay off" when the underlying stock or index fall -- can be a great form of insurance for your portfolio. And in true supply demand fashion, when optimism reigns, the price of put option insurance goes down (insurance is cheapest when no one wants it). 

So, as we round the corner into summer, buying long-dated puts on the S&P 500, or on select large "economic bellwethers" -- at current put prices General Electric (NYSE: GE  ) and Cisco (Nasdaq: CSCO  ) would be good candidates -- or the most vulnerable stocks in your portfolio, could give you a valuable hedge against any decline. As an added bonus, when the market turns rough, you can sell the puts back into the market for a profit when insurance is suddenly in much greater demand, and keep your stock for a rebound.

On a more granular level, you can also use a strategy called a collar to protect individual stocks that you own during uncertain times. Worried that Dell's (Nasdaq: DELL  ) upcoming earnings announcement will be poorly received? Sell a call option for every 100 shares owned, with a strike price a buck or two higher than the current share price, and then use the proceeds to buy a put a buck or two below the current stock price -- with both options expiring after the expected earnings date, you can set up your protective collar for little or no cost. You're protected against the stock price falling below the put strike price, although this protection comes at the cost of giving up gains in the stock price beyond the call strike.

Invest with less capital at risk
Options offer you the ability to risk less of your capital in a new position than if you just purchased stock. We'll demonstrate two ways investors can profit from a bullish thesis using calls. When you buy a call, you have the right to buy the underlying stock at a set price (the strike price) by a specified date (the expiration date). Let's use an example.

Long calls
Since Ford (NYSE: F  ) didn't take any bailout money, you believe it is best positioned to benefit as credit loosens and the economy continues to improve. Further, the fact that Toyota Motors (NYSE: TM  ) had recently stumbled makes you believe that Ford has its eyes on market share, and you want to profit from its share appreciation while putting less capital at risk in case the economy falters again. Instead of purchasing 100 shares for $1,120 you can risk just $218 by purchasing a $12.50 Jan. 2012 LEAP call options, allowing you to profit if Ford fetches more than $14.68 by expiration. Just like owning shares, your potential profit is unlimited, but your losses are capped at your investment of $218 if the shares are below $12.50 on expiration.

Bull call spread
You can also generate attractive percentage returns while putting only a little money at risk by using calls to set up a bull spread.

Suppose you think Apple (Nasdaq: AAPL  ) , off its recent iPad launch, is firing on all cylinders, and you believe the stock likely to finish out the year above $260. Though you are bullish, you think the stock is unlikely to rocket to $300, and you don't want your strategy to depend on that type of result. You are also not interested in purchasing 100 shares for $26,000. In fact, you'd like to make some real money even if it didn't go up at all, while only investing a fraction of that amount. 

By purchasing the Jan. 2011 $220 call and selling the Jan. 2011 $240 call, to establish a spread, you can achieve a maximum profit of better than 74% on your capital if the stock just stays above $240 by expiration. That's 74% if the stock is merely flat! The maximum profit ($8.55 per share) is the difference between the strikes ($20) minus the cost to set up the spread multiplied by 100 shares (currently $11.45 x 100). If the shares close below $220 on expiration, you will lose your entire investment of $1,145, but if your thesis proves correct, and the shares finish above $240, you will make $855 or 74% on your $1,145.

That's a pretty ripe idea.

Earn returns in a volatile or flat market
If volatility is the name of the game, there are many ways to profit from it using options. If you believe volatility is going to increase in either direction, you can buy a straddle: purchasing both puts and calls, with the same strike price, on a stock or index that you believe is going to make a dramatic move in either direction. If it does, one side of your straddle should generate large enough gains to provide profits overall. When Palm (Nasdaq: PALM  ) was $15 and the Pre was either going to save its life or be its death knell, a straddle would have paid off well when Palm declined to $5.

When you believe the market will stay in a range or be flat, you might want to write a strangle: selling covered calls on a stock you own at a higher strike price, and selling puts on it, too, at a lower strike price. With this strategy, you need to be ready to buy more shares if the stock declines, so you should only own about a half a position, and you'll be ready to sell your existing shares if the stock rises above your call's strike price. Both the puts and covered calls will pay you income, and if the stock stays in a range, the options will expire unused for a gain, and you can do it again.

These are just some of the reasonable, profitable and attractive strategies that options afford for any market, and that we're using in Motley Fool Options. Click here if you'd like to learn more.

Ford and Apple are Stock Advisor recommendations. The Motley Fool has a disclosure policy.


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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 July 28, 2010, at 3:03 PM, Glycomix wrote:

    Motley Fool is trying to help us, but we won't follow. It's like a cow at a new gate.

    The cow's thinking: "Yeah the grass may be nub high here and growing two feet high through the gate, but I've never been there. I'm not going to try it. We’ve never been there. You know, you could get hurt straying away from what you know!”

    Maaa.

    The head bull might say “Maybe, but you know you’ll starve if you don’t make the attempt.”

    I understand, These complex combination put and call option trades are a way of hedging your bets. You know which way things are likely to go, but you want to take only a moderate level of risk. The bear and bull option spread trades will hedge one's bet. It takes thinking and analysis, but one can learn how to do this properly.

    Because I couldn’t make money in the stock market, I'm paying big bucks to learn about how to trade options to make money from Investview, a crack brokerage teaching company. However, the Motley fool is trying to give you this same education for free! Why the crickets? Why the lack of interest?

    Fool Moderators, may I suggest a series on paper trading? Teaching people how to "paper-trade" options in a virtual fashion until they understand it well enough to make money at it. Almost all brokers allow you to paper trade for free. Scott, Interactive Brokers, Think or Swim.

    Moderator, if we non-technical investors won't trade, do a series on how to teach your kid to paper-trade. Of course present an account in which the investor have no REAL money, so the won't loose the nest-egg, the farm, the business and house while learning the "game". Kids figure out computer games in an instant. To them the paper-trading options game will a cakewalk.

    PAPER TRADE OPTIONS

    The stock market is risky and options more so, if you don't know the rules.

    What do you do? Learn the rules! When you play any game you have to learn the rules. At first you’re a mess, but you get better over time. Just stay patient. May I suggest that my fellow fools try virtually-trading options. That will lower the terror to manageable levels.

    Virtual or paper-trading is risk free. It's like playing monopoly except that you can see how well the strategies work.

    Of course use an UN-funded account to paper trade options with your kids. (For God's sake, don't put real money at risk. You're learning. Make it fun!) Reward them if they win. They can decide which video you'll watch on "Family Night at the Movies". Think of it this way. Instead of playing video games with the kids, virtual trade with your seven year old.

    There's no money nor risk. Think-or-Swim will give you $100,000 in virtual cash and let you paper-trade for free for a few months in hopes that you'll switch to them. Once your kids crack the code on how to trade options, they can teach you how to do it. You both can prosper: pay them to teach you how to play the "new video game".

    You have to explain different option hedges to your kids, bull and bear trades, the butterfly and the condor. However, they'll probably suck it in like the rules to a new video game. [Idea to Fool Moderators. Teach your kids about options. When they understand your lesson, we will]

    The outcome looks good. When you virtual trade your options your kids will learn how to make money in the stock market; and you will learn how to keep what little you're taking home and trying to invest.

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