Insure Your Portfolio Against Huge Losses

The stories of woe continue to trickle in. In 2009, 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 General Motors (NYSE: GM  ) , Morgan Stanley (NYSE: MS  ) , or Goldman Sachs (NYSE: GS  ) . 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 Apple (NYSE: AAPL  ) , Google (Nasdaq: GOOG  ) , and Baidu (Nasdaq: BIDU  ) , 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. 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 1,000 shares of Yahoo! (Nasdaq: YHOO  ) , currently trading at $13, you could buy 10 put option contracts (each contract represents 100 shares of stock) to insure your entire position against further decline. You're particularly concerned about the first half of 2009, so you might buy put options that don't expire until July 2009.

Today, it would cost you about $3 per share to insure a $13 sell price (strike price) on your Yahoo! shares until mid-July 2009

So, even if Yahoo! declined to $5 during the next 7 months, the put option owner would be able to sell out at $13 – for a net sell price of $10 after accounting for the cost of the puts.

If Yahoo! declines the next few months, and you still believe in its long-term potential, you can sell your puts for a profit and continue to own the shares.

On the other hand, if Yahoo! is $13 or higher by July (say it's $18), your $13 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 first 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 new $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 owns shares of Google, is long options on Apple, and is short options on Baidu. Baidu and Google are Rule Breakers recommendations. Apple is a Stock Advisor pick. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (43)

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 December 22, 2008, at 5:23 PM, ctstone wrote:

    Yikes, a 6-month insurance policy that costs 23% of the value of the stock. If home insurance were that expensive, a 6-month policy would cost the owner of a $250k house . . . wait for it . . . $57,500. I betcha not many homeowners are willing to spend half the value of their homes each year on insurance premiums.

    Instead of buying those puts, how about writing some? You could write 10 put options on Yahoo July 10s for $2. If Yahoo remains above 10 through July, you can pocket the $2,000 and go on your merry, profitable way. If YHOO closes below 10, you've bought yourself another thousand shares, but at a basis of $8 per share. Not bad. Its almost a full buck below the 52-week low that YHOO set on Nov. 20.

    That's not really speculation. Who wouldn't want a block of YHOO at $8? And if you don't think that's a good deal, well, you'd better sell that YHOO that you already own at $12+. Or better yet, maybe write some near-term-expiration covered calls, like January 12.5s for $1.12 -- giving you sales price of $13.62 if YHOO stays above $12.50.

    Options really are great tools. I've been writing puts lately to capture juicy stocks at their 52-week lows even though they've bounced an average of 15% off those lows. There's always risk and reward, but options aren't as scary as many people fear.

  • Report this Comment On December 23, 2008, at 12:59 AM, dividendgrowth wrote:

    This is one of the silliest articles here at TMF and a very DANGEROUS one!

    As the previous commenter has said, put premiums are dreadfully expensive. Some of the volatile stocks have annual put premiums making up 30-40% of the stock price!

    If you really fear that your stocks could be going down, sell them!

    If you really know that your stocks would be going down, sell them and buy puts!

    Forget about using puts as insurance!

  • Report this Comment On December 24, 2008, at 12:11 PM, TMFFischer wrote:

    This is just an example -- and a rerun article at that. The original October article used Citigroup at $23 as the example, and then too people said the puts were too expensive. With the stock now $7, the puts were a great purchase. That's Citigroup. Yahoo! probably isn't Citigroup. But either way, this is just an example of how the strategy is put into place. Sometimes put buying is a great move, sometimes it isn't. True of any investment choice.

  • Report this Comment On December 24, 2008, at 7:26 PM, ctstone wrote:

    Hey Jeff, the retrofitted piece chose a poor example of using puts. If readers are going to benefit from the example, it probably should be a reasonably attractive trade. Options are misunderstood enough already without adding silly, money-flushing scenarios to the investing fog.

    Anyhow, this post is more strident than I intended. Happy Holidays, man, and good trading to all.

  • Report this Comment On July 01, 2009, at 10:56 AM, jfish70 wrote:

    In my opinion, when properly used, options are the only way to go.

    I would never open a long position unless I had the downside protection of a LEAP. I was taught this a long time ago (late 90's) and have stuck to it. My average return is near 12%.

  • Report this Comment On July 13, 2009, at 12:52 PM, TWPBrandon wrote:

    Options are an extremely useful investment tool. Important to know the risks involved however such as increased volatility.

  • Report this Comment On August 09, 2009, at 5:28 PM, jerome7777 wrote:

    When a commentator tells the viewer its time to take some money off the table, do they realize the ramifications of this in taxes and commissions? This recent market has given me great gains but they are mostly short term and I will gladly buy a put as insurance and like most insurance I would LOVE to lose the premium!

  • Report this Comment On August 10, 2009, at 7:55 PM, mikenrobin wrote:

    I have shares of a stock that is currently at about $4 and I believe it will go to $5 or $6 by the end of the year. How would I play this belief with options? I'm trying to get my feet wet .

  • Report this Comment On August 14, 2009, at 4:29 PM, FoolForOptions wrote:

    "I have shares of a stock that is currently at about $4 and I believe it will go to $5 or $6 by the end of the year. How would I play this belief with options? I'm trying to get my feet wet ."

    Without knowing the specific stock it's hard to tell you for sure since I can't see what contracts are available. You could consider selling a $7.50 December or later Put. Is this worth it? That will depend on what the price of the option would sell for, Open Interest in the contract, etc.

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