Option Insurance for Nervous Investors

Protective puts can limit downside risk while leaving room to run.
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Investors who are worried about the sustainability of this summer's rally but who don't want to miss out on further upside might want to consider protective puts.

With the

S&P 500

up 7% since the start of May, a defensive posture will appeal to some investors. The current rally has climbed a particularly daunting wall of worry, one that has included higher oil prices, a

Fed

tightening cycle and persistent talk of a housing bubble.

If you're long the market, or considering buying stocks, a protective put or so-called "synthetic call" can serve as a backstop should the bet turn sour.

"Buying a put to protect against a long stock position is insurance; just like you would buy insurance against your home, your life, and your car. Why wouldn't you buy it against your portfolio?" says Walter Haslett, president and chief investment officer at Write Capital Management. "Considering how low volatility is, insurance is now at its

cheapest point in almost 10 years."

A synthetic call is easy to understand. It is when an investor is long a stock and buys a put at the money or slightly out of the money (i.e., has a strike price below the market price of the stock).

Here is the risk/reward of the trade:

The maximum reward is unlimited.

The maximum risk is the stock price, plus put premium, or price of the option, minus the put strike price.

The break-even for the trade is strike price, plus put premium, plus stock price, minus put strike price.

The strategy has several possible outcomes. If the stock price falls below the strike price before expiration, an investor can exercise the put and sell the stock at the strike price. He could also sell the put outright and hold the stock in the hopes it will later rise. If the stock rises above the break-even point, an investor might sell the stock and hope for it to fall, then sell the put after it regains some of its value.

All things being constant, an option will lose value as it approaches the maturity of the option. For this reason, look to purchase puts that will expire in about six months or so. That way, there is more time for your position to be successful.

Let's take a look at a few examples of initiating a synthetic call position.

National Semiconductor

(NSM)

was recently trading at $25. The stock has performed well the last year and you believe it can go higher, but you want to limit downside risk. You would simply buy 1 January 2006 put for every 100 shares owned. The puts were recently trading at $2. Let's assume you purchased 1,000 shares at $25 apiece. Your maximum risk would be: stock price $25, plus put premium $2, minus put strike $25, which comes out to $2, or $2,000, which is the amount you paid for the puts. Your break-even for the trade would be: put strike $25, plus put premium $2, plus stock price $25, minus put strike $25, which comes out to $27. So in order to make money to the upside, NSM needs to trade over $27.

Now, let's assume you were long

Yahoo!

(YHOO)

at its current price of $34.50. With the uncertain outlook of technology, say you wanted to protect yourself from downside. Let's assume again that you own 1,000 shares. You would buy the January 2006 32.5 puts for $1.50. Your maximum risk in this trade would be: stock price $34.50, plus put premium $1.50, minus put strike $32.50, which comes out to $3.50, or $3,500. Your break-even for the trade would be: put strike $32.50, plus put premium $1.50, plus stock price $34.50, minus put strike $32.50, which comes out to $36.

As you can see, the lower the put strike, the cheaper the option. But it takes a bigger move for the insurance to kick in. On the other hand, you need the stock to rise only $1.50 to make money.

Whether you purchase an at-the-money or slightly out-of-the-money put is up to you. It depends on your outlook for the stock and what you are comfortable with. If you are very bullish on the stock, pick an option that is out of the money, which will cost less. But if you want to limit your downside as much as possible, pick a put at the money. Try to pick options that are liquid and fairly priced. Illiquid stocks tend to have a wider bid/ask option market and are more expensive due to the inability to hedge.

Just like any other type of insurance, a protective put can enhance a sense of comfort. It gives the investor downside protection while allowing him to take part in any upside gain in the stock.