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Booyah Breakdown: Know Your Options, Part 2

Tracy Byrnes

Editor's note: Welcome to "Booyah Breakdown," an explanation of terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.

A few weeks ago, we deciphered the lingo of options traders. So now that you know the code words, let's get in the trading pit and use them.

Remember, we said options are like insurance. The difference here is that your option insurance can actually make you Mad Money.

Today, we'll see how you can use options to protect your current stock holdings. There are two basic strategies you can use -- a protective put and a covered call -- so read on to learn how.

Put on Some Protection

If you own a stock and want to keep it but are worried that something detrimental might happen to the share price, consider a protective put, suggests Tom Boggs, associate director of equity products at the Chicago Mercantile Exchange.

Let's say you're afraid your company is about to announce some bad news, and the stock will take a hit -- or that the upcoming elections are going to hurt share price -- but you still believe in the stock's long-term potential. In those cases, you could consider buying a put to protect your existing gains.

Or if you've owned your favorite stock for less than a year, but want to wait until you have it for a full year to sell it and take advantage of the lower 15% long-term capital gains tax rate, a put could help you secure your profits until that time period is up, says Marty Kearney, senior staff instructor at the Chicago Board Options Exchange's Options Institute.

In either case, the options folks say you're buying a protective put -- a.k.a. a married put -- because you own the underlying shares.

Remember, a put gives the holder the right to sell an asset at a certain price within a specific period of time. So if the stock price falls below the strike price before the expiration of the option, you could exercise your put option and sell your shares at the strike price.

If the stock's price jumps above the strike price, you would just let the option expire worthless, losing only the option price -- your insurance premium.

We need an example. Let's say you own Proctor & Gamble , which has been hovering around $63, and you believe the market is shifting into a bearish phase. However, since you bought the stock at $53 back in April, you'd like to protect your profits and try to hold the issue for at least a year before you sell.

So consider buying the PG Apr $60 put, which costs around $1.90, says Tom Gentile, senior vice president & chief options strategist at Optionetics, an options-education site. This, in essence, ensures you a sale price of $58.10, which is the strike price -- $60 -- minus the premium paid -- $1.90.

Remember, each option covers 100 shares, so you'll need to cough up $190 to protect 100 shares of PG. But that put will enable you to sell your shares at a strike price of $60 if the stock falls.

Let's imagine the stock does tank and is down to $58 by next April. You decide to exercise your put before expiration day, the third Friday of the month. So instead of selling each share for $58, which is what it's trading for in the marketplace, and realizing a $5 gain on each share ($58-$53), your put allows you to sell for $60 and bump your gain to $5.10 per share.

That's because your profit is equal to the strike price less the stock purchase price, plus the premium paid. In our example, that's $60 - $53 - $1.90 = $5.10. So you are securing a $5.10 profit per share.

Your insurance worked.

If, on the flip side, the stock kept going up in price, you'd just let the option expire and be out $1.90. But at least you would be able to sleep at night.

Cover-Up With a Call

But what if you think the stock is going to be flat for a bit, even though you see big upside potential in the long term? Maybe you think the market will be at a standstill because of the upcoming elections. Consider selling a call and getting paid while you wait for the stock to hit its price, suggests Kearney.

Remember, a call gives the holder the right to buy an asset at a certain price within a specific period of time. So in this instance, you could write (sell) a call option on your existing shares, says Gentile. The options guys call this a "covered call" because you already own the shares to "cover" your obligation if the option gets exercised. (If you buy the stock at the same time you write the call contract, the folks in-the-know call that a "buy-write.")

So let's say you own PG and believe the stock will trade relatively flat in the short term. You decide to sell a call option on PG for $65 at, say, $2. You immediately get the premium -- the $2 -- from the option sale. If PG doesn't move before expiration day, the option expires worthless, but you have two extra dollars in your pocket thanks to the option you sold. Nice.

But what if PG rises to $68? The option you sold would most likely be exercised, and you'd have to give up your shares. You'll have to sell them to the option holder for $65 (the strike price of the option), even though they're trading on the open market for $68.

But all is not lost -- you still have the $2 premium from the sale of the option. This caps your effective sell price at $67, which is the strike plus the premium collected from the sale of the call option.

So your overall profit here is the difference between the strike price and your original purchase price, plus the premium from the option: $65 - $53 + $2 = $14

Finding Your Options

While talking about health and car insurance may be a totally snoozer, it's easy to see how you can get fired up about options insurance. Because in many instances, it's almost a no-brainer.

So talk to your broker about buying options as insurance. You'll need to establish an options account at your brokerage firm, but then buying and selling them should be relatively straightforward.

And if having a little insurance is going to help you stop tossing and turning in bed at night, then by all means, get educated so you can protect yourself.

Your spouse -- and your mattress -- will thank you.