The big bounce in stocks we've seen recently has given beaten-down investors some relief after seeing their portfolios suffer big losses last year. But now many are concerned that the rally may be ending, and they don't want to lose everything they've earned back.
One simple method that can preserve your wealth against falling stock prices is to buy put options. By owning puts, you can ensure that even if your shares drop in value, you can sell them at the price you pick within a certain period of time.
Time to take profits?
Of course, put options get pricey for volatile stocks. When demand for protection increases, especially during panics like the two we saw this past fall and winter, you'll pay more for puts.
To measure how much options cost, options experts look to the S&P 500 volatility index, or VIX. While the VIX went to unprecedented high levels last October and November, it's now fallen back to its lowest levels in nearly a year. If you want to protect your stocks and lock in the gains in your portfolio from the past five months, then you can do so now without spending as much as you would have to buy puts in the recent past.
Take a look at these examples of stocks on which you can buy puts at reasonable prices right now:
|
Stock |
Recent Share Price |
Put Option |
Recent Option Cost |
|---|---|---|---|
|
Wal-Mart Stores (NYSE: WMT) |
50.83 |
Dec. $47.50 |
1.45 |
|
BP (NYSE: BP) |
50.21 |
Jan. 2010 $45 |
2.00 |
|
Monsanto (NYSE: MON) |
83.59 |
Jan. 2010 $75 |
4.70 |
|
Research In Motion (Nasdaq: RIMM) |
71.63 |
Dec. $60 |
3.85 |
|
United Technologies (NYSE: UTX) |
57.59 |
Jan. 2010 $55 |
3.70 |
|
Microsoft (Nasdaq: MSFT) |
23.41 |
Jan. 2010 $22.50 |
1.61 |
|
Bank of America (NYSE: BAC) |
16.23 |
Jan. 2010 $14 |
1.33 |
Source: CBOE. Prices based on bid-ask spreads as of 10 a.m. Aug. 13.
Which option you pick depends on how long you want protection and your willingness to give up some of your profits. You'll pay more to buy puts with more time until expiration, puts on volatile stocks, and puts with higher strike prices. Take care how much you spend on puts, because you may end up not needing that protection at all.
Buying peace of mind
Conceptually, put options are a lot like an insurance policy. If your stocks fall, paying a relatively small amount to limit your losses may well be worth it.
If, however, shares rise or even stay flat, you would lose the entire premium you paid on most of the options listed above. In fact, if your option's strike price is below the stock's current value, you could actually see your shares drop and still suffer a complete loss on your put option.
Puts are expensive enough that you don't want to count on them as a permanent fixture in your portfolio. As you can see from the Bank of America put listed above, you'd pay more than 8% of the current stock price to limit your potential losses to 14% -- and even that option lasts for only five months. Still, if owning a put makes you feel more comfortable staying invested in the market, then your future gains could well make what you spend on puts look like chump change.
All about options
Profit protection is just one goal you can achieve using options. To learn more about smart ways to use options, check out our just-released free video series -- simply enter your email in the box below for access.
