A couple whose retirement is in doubt because they had too much of their portfolio in presumably solid, safe companies. 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.

It's twice as difficult to hear 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 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 Yahoogleazon!, 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.  

It might cost you about $3 per share to insure a $13 sell price (strike price) on your Yahoogleazon! shares expiring in 7 months.

So, even if Yahoogleazon! 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 Yahoogleazon! 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 Yahoogleazon! 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, 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.


This article was originally published on Oct. 1, 2008. It has been updated.