Many investors who've benefited from the huge run in the Dow Jones Industrials (DJINDICES:^DJI) over the past four years have started to wonder whether they should keep pressing their luck. With gains of almost 120% from the 2009 lows -- not even including the positive impact of dividends that investors have received along the way -- the market's lofty heights are enough to make even those with long-term investing strategies feel a touch of vertigo.
If you want to protect yourself from the potential for a sizable decline in the Dow, there are strategies you can use that will act as insurance for your portfolio. By buying protective put options, you can gain exposure to securities whose value will go up if the Dow goes down. But as with any type of insurance, you'll end up paying for the protection that put options provide. Are put options worth it right now? Let's look at how much an options-based insurance policy will cost you.
How put options work
When you buy a put option, what you get is the right to sell the asset underlying the option at a set price during a fixed time period. Many options allow you to exercise at any time before they expire, but after the set expiration date, the option becomes worthless.
CBOE Holdings (NASDAQ:CBOE) offers micro-options on the Dow for which the price is based on a figure equal to 1% of the Dow's value. So for instance, at the close last Friday, you would have spent about $100 per contract to buy a put option with a strike price of 142 -- corresponding to a Dow value of 14,200 -- that expires in the middle of next month.
That may not sound like much, but consider the following outcomes:
- If the Dow rises between now and mid-May, then you'll have lost your entire $100. The Dow's gains might offset your put losses, depending on how big a rise the market posts.
- If the Dow stays flat or falls slightly, you could still lose the entire $100 you spent on the option. As long as the Dow finishes at or above 14,200 -- 350 points below its current value -- the option will expire worthless.
- Only if the Dow falls below 14,200 will your option be worth something at expiration. To offset the $100 you paid for it, the Dow would have to drop to 14,100 or below, with the option gaining $100 more in value for every further 100-point Dow decline below that level.
What about individual stocks?
You can buy put options to protect against declines in particular stock positions as well. Often, though, those prices will be even higher on a proportional basis than broader index options, as the risks in a single company are much greater. For instance, if you'd bought put options on Thursday to sell IBM (NYSE:IBM) for $200 with just a week before expiring, you would've paid $2.35 per share. Of course, given the stock's $17 decline on Friday, that trade would have worked out, as the option closed Friday at $9.75 -- more than quadrupling in value.
The safer way to manage risk
Buying put options provides insurance, but it comes at a hefty price. For many investors, the simpler method of scaling back on risk levels in your portfolio by rebalancing when your stock allocations get higher than you're comfortable with is usually the better bet. But if you really want protection against a short-term move, then buying put options can sometimes be worth the cost.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool owns shares of IBM. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.