Consider Put Options for Protection - dummies

Consider Put Options for Protection

By Paul Mladjenovic

Many people buy puts as a way to speculate, but you can consider using put options in an entirely different way: as insurance or hedging.

Suppose you’re a long-term investor, but you’re worried about the next few months. You’ve been reading reports about problems in the general economy, or maybe some worrisome issues are arising in an industry you’ve invested in. Maybe you have a long-term holding in a stock that you bought years ago and it has a large unrealized gain, but lately you’ve been concerned because the stock is up at a dizzying level according to the P/E ratio or the RSI shows the stock is very overbought.

In that case, why not buy a short-term put option on your own stock? Because the option is short-term, the cost won’t be great, and it could give you some peace of mind.

Say you own 200 shares of a stock that is at $75 per share. Given the concerns just cited, consider buying two put options that will expire in less than six months. In that case, buy two put options at a strike price of $75, $72.50, or $70. If the stock goes up, the puts would of course lose value or expire worthless, but that isn’t a big concern — the stock is the big concern.

If the stock goes to, say, $65 per share and you have two put options at the strike price of $75, your 200 shares may be down a total of $2,000, but the put options can gain $1,000 per contract, so two contracts can have the power to gain $2,000 total. The put options gain value, which in turn offsets the downward moves of the underlying stock positions to a great extent.

You don’t buy these puts because you want to profit from the put options; you do it to offset any potential short-term downside moves by your stock. Obviously, the main concern is your primary (long) position in the stock. In the same way you don’t want your house to burn down just because you have fire insurance, you don’t want to see your stock go down just because you have a put on it.