This Last-Minute Move Could Save Your Retirement

There's no good time for the market to plunge. But for investors approaching retirement, there couldn't have been a worse time for stocks to fall than last year.

If you had only a few years left to go before retiring, you were probably among those hit the worst by last year's bear market. In general, younger investors hadn't yet had time to accumulate nearly as much wealth, so even those who were more aggressively invested didn't have as much to lose as those getting close to the finish line. Conversely, many of those who had already retired had moved to a more conservative portfolio, protecting themselves against exactly the adverse market move that occurred.

So after suffering some huge losses, the recent rally was exactly what the doctor ordered. Now, though, you probably want to make sure you never go through a repeat of 2008. And with a certain strategy involving options, you can protect yourself against further downside risk while simultaneously giving yourself an exit strategy to build a more conservative portfolio in retirement.

Protection ... at a price
The simplest way for shareholders to protect themselves against a potential stock drop is to buy put options. Put options give you the right to sell your shares for a guaranteed minimum price, even if the shares fall below that price on the open market.

Although put options give you solid insurance against a bear market, that protection doesn't come free. In fact, buying puts can get expensive in a hurry, especially if you want to protect yourself for a year or two. You could easily end up spending 10% of the stock price or more to buy a long-term put option.

Cutting your cost
If that sounds too pricey to you, then there's an alternative that makes a lot of sense for investors who are looking to tone down their portfolio's risk level in the near future. By writing covered calls, you can earn enough money to pay for protective put options.

For instance, say you own shares of Coca-Cola (NYSE:KO), which closed yesterday around $55 per share. If you wanted to buy a put that would limit your loss to $5 per share until January 2012, you would have had to pay around $5.75 per share. However, if you were willing to limit your gains to just $5 per share, you could also have written a covered call that would pay you about $3.85 per share. In all, you would've paid just $1.90 per share for over two years of protection.

In 2012, even if Coke shares had fallen sharply, you'd always get at least $50 for your shares by exercising the put option. If the shares rose above $60, though, then the covered call would get exercised, and you'd miss out on any additional gains. However, if you're looking to cut back on your stock exposure anyway, then you would have succeeded in selling those shares at a reasonable price and raising more cash in your portfolio -- plus you'd earn a nice profit for your trouble.

Here are some other examples of how this strategy would work for a number of different timeframes.

Source: Chicago Board Options Exchange. Prices based on closing bid-ask spread as of Oct. 13.

As you can see, sometimes the strategy will even pay you some money back, if the covered call earns you more than the put option costs.

Another nice thing about this strategy is that if the stocks you own pay dividends, you'll continue receiving them unless your covered call gets exercised. That's one way in which using options can work out better than simply selling your shares immediately.

Protect yourself
If you've just recovered from staggering losses, the last thing you want to do is to put your retirement in jeopardy again. With an options strategy that combines the protection of put options with the income of covered calls, you can position yourself perfectly for the last years of your career.

Want to know more about options and how they can help your investing? Start here with this introductory article from Foolish options expert Jim Gillies.