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Options That Protect Against Plunges

These strategies help protect profits when markets dive.

This article has been adapted from a RealMoney blog post that originally ran in November 2007. Click here to take a free trial to Steve's newsletter, Options Alerts.

Wall Street often engages in exotic trading strategies that involve fantastic if not phantom products, whose behavior in times of chaos might not act as originally predicted.

And the response from professional investors is not all that different from that of retail investors, in that both need ways to manage and control risk. That starts by being able to measure or gauge changes in valuation of positions under different circumstances and scenarios.

For option traders, that means being able to see the risk profile of a position as different variables change, such as time, price and implied volatility. Some of the best starting points -- essentially free -- would be to use online brokerage firms that cater to option traders.



ThinkorSwim online brokerage division has some great risk and pricing tools, as do



and two relatively new deep-discount brokers,




, which offers tools such as a

position simulator.

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Moving toward third-party vendors and software providers, offers a variety of subscription-based analytical tools. It also has plenty of free tools such as an option calculator.

One of my favorites is One of the things its programs does particularly well is translate how changes in all the variables, including the Greeks, such as vega, which as

already discussed ties implied volatility to money, affecting the actual dollar valuation of a position.

I actually don't get too caught up in the difference in option pricing models, because I just accept that the price is the price, and there is nothing I can do to change it. But it is important to understand how each variable will affect the price and then run through a variety of scenarios, including the worst case, to get a handle on the risk profile of your position.

At that point you can start to see what options are available to reduce your risk. At the most basic level, it may mean just keeping an inventory of puts on index or sector products. One can use this

portfolio protection calculator to determine the number of puts one must buy to gain protection for a given percentage decline over a specific time period.

Many market makers will use way-out-of-the-money spreads, especially butterflies, to keep the cost down. These positions will not change much in value until they move into the money. But once that defense stance is established, you can turn your attention to going on the offensive when the market gets messy. You might find yourself able to quickly clean up and emerge as one happy cat.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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