Four ways to protect your stock portfolio using options. Use these strategies to handle the market’s surprises.
Many investors have heard horror stories about options. “They’re too risky, too complicated, and too speculative,” some have warned. Contrary to that belief, options are not always risky or complicated. In fact, as you understand the advantages and disadvantages of options, you’ll appreciate how you can use options in conjunction with stocks. Although most investors’ primary goal is to earn profits, one constructive way of using options is to protect your stock portfolio from disasters. Here are four strategies to consider:
1. Sell a covered call. This popular options strategy is primarily used to enhance earnings, and yet it offers some protection against loss. Here’s how it works: The owner of 100 (or more) shares of stock sells (writes) a call option. The option buyer pays a premium, and in return gains the right to buy those 100 shares at an agreed upon price (strike price) for a limited time (until the options expire). If the stock undergoes a significant price increase, that option owner reaps the profits that otherwise would have gone to the stockholder. Thus, the covered call writer sacrifices the possibility of earning profits over and above that previously agreed upon price — in exchange for that real cash payment. Additional details are required to gain a complete understanding of this idea, but the basic premise is this: cash now in exchange for profits that may never materialize.
2. Buy puts. When you buy puts, you will profit when a stock drops in value. For example, before the 2008 crash, your puts would have gone up in value as your stocks went down. Put options grant their owners the right to sell 100 shares of stock at the strike price. Although puts don’t necessarily provide 100 percent protection, they can reduce loss. It’s similar to buying an insurance policy with a deductible. Unlike shorting stocks, where losses can be unlimited, with puts the most you can lose is what you paid for the put. By picking a strike price that matches your risk tolerance, you guarantee a minimum selling price — and thus the value of your portfolio cannot fall below a known level. This is the ultimate in portfolio protection. The reason the vast majority of conservative investors don’t adopt this strategy is that puts are not cheap, and this insurance often costs more than investors are willing to pay. Yet the protection a put provides just may be priceless.
3. Initiate collars. Collars represent the most popular method for protecting portfolio value against a market decline. The collar is a combination of the two methods noted above. To build a collar, the owner of 100 shares buys one put option, granting the right to sell those shares, and sells a call option, granting someone else the right to buy the same shares. Cash is paid for the put at the same time cash is collected when selling the call. Depending on the strike prices chosen, the collar can often be established for zero out-of-pocket cash. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of his or her holdings. This is an ideal tradeoff for a truly conservative investor.
4. Replace stocks with options. The three previous strategies are relatively easy to use and involve little risk. The stock replacement strategy, on the other hand, can be tricky. If not done properly, the investor’s portfolio can vanish. The idea is to eliminate stocks and replace them with call options. The point of this strategy is to sell stock, taking cash off the table. The stocks are then replaced by a specific type of call option — one that will participate in a rally by almost the same amount of stock. Ideally, the chosen stocks can incur only limited losses when the market declines. This strategy is similar to buying puts: limited losses, profit on rallies, and costly to initiate. For example, let’s say you own 300 shares of XYZ Corp. You have a nice profit that you want to protect. The stock is currently at $54 per share. You sell the shares and buy three call options with a 50 strike price (giving you the right to buy shares at $50). You choose a fairly long time period — perhaps one year (minimizing commissions to replace options as they expire). It’s crucial to replace stock with options whose strike price is lower than the current stock price. The risk for inexperienced investors is that they may choose less expensive call options (out of the money). That is far too risky because there’s no guarantee those options will increase in value.
These four strategies are designed to protect a portfolio against varying amounts of loss. Don’t assume that they also guarantee profits. In fact, before using any option strategy, the best advice is to consult with a professional to both gain a more thorough understanding of what it is you are attempting to do and the best advice in how to do it.
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The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm. Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.