Protect Your Stocks in a Scary Market

With the European crisis having already pushed one financial company into bankruptcy and seemingly getting more unsettled every day, even long-term investors are on edge. But rather than simply watching your hard-earned money go up in smoke like it did in 2008 and early 2009, you can take steps to protect yourself against further losses in the stock market.

Of course, that protection isn't free, and it doesn't necessarily come cheap. But if you'd rather be safe than sorry -- or you're hoping to profit from a downward move on a particular stock -- then there's a simple options strategy you can use: buying put options.

Join the dark side
Most investors tend to be naturally optimistic, looking for their investments to go up over time. By comparison, relatively few investors use bearish strategies extensively. One reason is that the risk-reward equation from bearish trades like short-selling can be scary. When you buy a stock, the most you can lose is what you paid for it; but when you sell a stock short, you can lose far more than the then-current value of the stock if it soars.

Put options are a great way to control your risk of loss while still benefiting if the underlying stock goes down. To buy a put option, you choose a stock, a length of time for the option to remain active, and an exercise price at which you'd like to sell your shares. You then pay a premium to whoever sells you the option. In exchange, you have the right to sell those shares at any time until they expire for the agreed-upon price.

That puts you in control of your option strategy. If the stock drops below the exercise price of the option, you can go ahead and use the option to sell your shares above the now-fallen market price. Conversely, if the shares don't fall that far, you're under no obligation to sell -- you can just let the option expire unused. Either way, though, the premium you paid upfront is a sunk cost, either offsetting the profit if you exercise or representing a loss if you don't. Still, that can be a small price to pay compared to the big losses that outright short-selling can incur -- or the lost profits that come from selling a stock outright to prevent possible losses.

Are put options too expensive?
As an illustration, let's take a look at some much-hated stocks from Motley Fool CAPS. These picks are all bottom-rated one-star stocks that some would see as good short candidates. Here they are, along with prices for representative put options:

Source: Yahoo! Finance. Prices as of Dec. 8 close.

As I said before, buying puts can be pretty expensive. Based on the prices above, getting even partial protection from major declines will cost you 5% to 10% or more of the stock's price, and you only get that protection for a few short months. There are cheaper options out there, but they give you even less protection.

The upshot is that you can't really expect to use put options as a permanent insurance policy against losses. They're really best for short-term hedges when you expect important news to have an impact on the shares, such as Pharmasset's imminent takeover from Gilead Sciences, the investigation of Green Mountain's accounting practices, or MBIA's ongoing lawsuits with big banks.

Keep your options open
Buying puts can protect you from losses or help you make profits from the short side. But it's just one way you can use options to make big money.

This month, we're offering you a free look at the Fool's "Options University." It's only available for a limited time, though, so go ahead and enter your email address in the box below now to learn more about how options can fit into your portfolio.