The Smart Alternative to Selling These Winners

Financial markets are behaving strangely, and it has a lot of investors completely freaked out.

By now, you've gotten used to the news of the dollar's steady, consistent drop day after day. Gold has hit record highs regularly for weeks now and shows no signs of stopping. The stock market has benefited not just from the rise in commodity-related stocks but from general optimism among investors of all sorts. Even bonds, which you might expect would suffer in such a pro-stock environment, have posted surprising gains and drawn a lot of investor interest.

It's kind of like when your kids don't fight, your in-laws are nice to you, and your dog stops barking through the night. You just know something's about to happen -- and it's probably going to be something you don't like.

2 ways to protect yourself
So if you're convinced that a return to the Armageddon-like days of last fall are inevitable, what can you do to lock in the amazing gains you've seen over the past eight months?

The most obvious way is simply to sell everything. Hit the emergency exit button on your brokerage account, hock the gold coins and silver bars you just bought on eBay, and go deposit your fortune among enough different banks to take advantage of the $250,000 FDIC limit on your entire stash. Then sit and wait -- collecting a pittance in interest all the while -- for everything to go bad.

That's fine if you have perfect timing. But what happens if the things you just sold continue to rise in value? What will you do next? You're left with some unappetizing choices:

• Buy back what you sold at higher prices. Not only does that cost you money, but you're left with exactly the same risk you had when you started.
• Keep waiting. You can join everyone who said the rally would end two months ago, four months ago, and six months ago. Bring a good book, because you could be waiting an awfully long time.

Even worse, selling everything immediately triggers a capital-gains tax on all your profits. If you just picked up shares a few months ago, you'll have to pay your full ordinary tax rate on those gains -- a bite you really don't want to pay right now.

If you don't want to face that dilemma but want to protect yourself against even the slightest loss, there's another thing you can consider. Rather than dumping everything and hoping you have good timing, you can turn to options for the insurance you're looking for.

Running the option
Buying put options is the simplest way to use the options market to protect your portfolio. By specifying a particular length of time and the minimum price you're willing to accept for your shares, you can find the right option to match up with your current holdings. If your stocks drop in price, you exercise your option and collect a higher amount. If they keep rising, you're not obligated to sell and instead get to keep the profit for yourself.

As you'd expect, put options come at a cost. And even with the market in a firmly established uptrend that makes puts less popular than when stocks are plummeting, that cost is still pretty high. Here are some examples of put options that give you two to six months of protection, using stocks that have posted some big gains in recent months.

Source: Chicago Board Options Exchange. Closing prices as of Nov. 16.

You can see that short-term protection from a market reversal certainly isn't free. With some of these options costing 10% or more of the stock price, buying put options is not something you want to do constantly -- but at appropriate times, doing so might be worth the price.

Have your cake and eat it, too
So if you're thinking about getting out before the last best asset bubble finally bursts, consider your other option: options. If you're not sure stocks won't rise even further, then options may give you a better solution to your risk problems.