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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.

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.)
Research In Motion
(Nasdaq: RIMM  ) is an excellent example. Suppose you own 100 shares of this volatile $58 stock, and you want to protect it against further big declines. A big risk for the company is Apple's push into Research In Motion's stronghold -- enterprise sales. Apple has even hired several former managers of Research In Motion's enterprise sales team.

To protect yourself, July 2011 put options with a $50 strike price (the price at which you could sell your stock, guaranteed) cost $3.60 per share.

So it will cost you $360 to insure your $5,800 Research In Motion position from now through September 2010, when these options expire. It's expensive, but the insurance would be great to have if the stock falls below $50, as it did in August. No matter what happens, you'll be able to sell your shares at $50 -- but it's a net sell price of $46.40 after factoring in what you paid for the put options.

"But wait," you're saying, "I have to pony up $360 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 100 shares of Research In Motion, you could write -- meaning sell -- a call option (each option contract represents 100 shares) on your stock for an immediate payment.

Research In Motion's $70 June 2011 call options are paying $3.60 per share. You could sell call option contracts on your 100 shares, be paid $360, and then use the money to buy your $50 put contracts for $360. So your net cost would actually be zero (commissions aside). In some cases, it can even be negative.

The catch, however, is that your upside is now limited. If Research In Motion increases above $70 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 $70 per share. So, even if Research In Motion soars beyond $100, as long as you have these open call options, you'd be forced to sell at $70.

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, Research In Motion.

A collar is a useful tool in bear markets, or when you are uncertain about a business. In 2008, that would have applied to just about any company related to financials. With monetary policy attempting to produce a narrower yield curve and potential liabilities from botched securitizations, JPMorgan (NYSE: JPM  ) and Bank of America (NYSE: BAC  ) (now the proud owner of Countrywide) could be facing trouble ahead.

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 Las Vegas Sands (NYSE: LVS  ) with its high expectations, Vonage (NYSE: VG  ) with its leverage, or Sandisk (Nasdaq: SNDK  ) which is fighting to avoid commoditization.

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? Motley Fool Options is offering a free report designed to get you up to speed on options basics. Just enter your email in the box below to find out more.

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

Jeff Fischer doesn't own shares any companies mentioned in this article. Apple is a Motley Fool Stock Advisor pick. The Fool owns shares of Bank of America, Apple, and JPMorgan Chase. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (1) | Recommend This Article (2)

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 November 29, 2010, at 4:46 PM, gfbjohn wrote:

    I'm just a bit scrambled about this. I kind of get the general idea. However if you write a call option, aren't you locked into keeping the stock to back the option? I think of owning stock as being akin to riding valuations escalators over time, any one of which could go down, flat or up and at various angles. Ideally one wants to be riding the escalators that are smoothly going up at the steepest angles. As noted in the article, neither smooth nor up is guaranteed. If I'm stuck holding a stock as collateral for an option and it is patently obvious at some point in the duration of that hold that there is some other escalator that is or will be going up steeply, I have to forgo that opportunity because of the option shackle.

    If indications are that my stock is on its way down, I'd rather be out of it than rely on a put to save me, unless it's a stock like MSTR, MOT or RMBS, which have histories of precipitous drops after announcing earnings misses, court rulings or other significant events.

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