Using Leverage to Reduce Risk

An Apple Today

Let's use Apple (AAPL Quote) as an example, as it has a relatively high beta of 2.24. That means if the market at large or, say, the S&P 500 rises or falls 1%, shares of Apple should experience a 2.24% change in price. So, as a stock that is expected to move or produce returns, profits or losses, more than twice that of the broad market, one can consider it fairly risky, and therefore its insurance will be relatively expensive.

With Apple currently trading around $131 a share, you can buy the April puts with a January 2008 expiration for $15 per contract. Assuming you owned 1,000 shares of Apple, a reasonable amount of coverage might involve buying 10 of these puts, which would cost $15,000, or nearly 16% of your investment.

What do you get for that 15 grand? First, understand that currently the delta of these puts is around 0.50, meaning that for each $1 move in the price of Apple shares, you can expect the value of the puts to move 50 cents. So, at the moment, your deductible on any initial decline in the stock price is around $7,500, or 5.7% of the investment.

But since delta moves on a slope, meaning it increases as the options move further into the money, your full coverage -- or where the value of the 10 put options will increase on a 1-to-1 basis for each dollar decline in Apple stock -- will begin at around $115 per share.

A Pre-Emptive Strike Price

Now how does that compare to simply selling off shares to reduce your margin requirement? Selling 1,000 shares of Apple at $115 will result in the same $15,000 loss as buying those puts, but it still leaves 900 shares, or some $103,000, exposed to further losses.

The leverage provided by the put option prevents incurring any further losses over the next eight-month period. Also, you still own that full 1,000 shares, meaning you retain the same upside potential should Apple resume its rally.