How to Use Options to Protect Your Portfolio

NEW YORK (TheStreet) -- Options are investment tools that can be used in a variety of ways. While many professional traders use them for speculation, they can also be powerful hedging tools when applied properly.

Basically, options are contracts that give buyers the right, but not the obligation, to buy or sell a stock or security at set price at a future date. Listed options are available for most actively traded stocks and ETFs today.

If you have a stock or ETF that you want to protect for a certain amount of time, options can be one way to achieve that. For example, you may have a position that you want to sell, but don't want to liquidate it in the current calendar year for tax reasons. Selling it next year would be better for you but you're afraid of the stock losing value. Perhaps you want the money for specific purpose, like a home purchase, helping someone with college tuition or starting a new business.

Another time investors use hedges are for upcoming economic events on the calendar. Maybe you're concerned about an earnings report on a particular stock. Or there's a Fed meeting and you want some protection during the announcement in case of an adverse market reaction.

Understanding how options work in these circumstances can help you decide what's the best strategy for you. Keep in mind though, that options are not suitable for all investors, there is risk involved and they can be complicated to execute. There is also the potential for large losses when not done properly. You should read the options disclosure document on the Chicago Board Options Exchange Web site for more information.

If you don't want to sell your position you can use options to protect it. How? As long as your holding has listed options trading on it, you can always purchase put options. A put option will give you the right to sell your stock at a given price by a certain date. That's known as the strike price and the date is the expiration.

Options can be purchased in, at, or out of the money. A put "in the money" is above the current stock price, while an "at the money" put is equal to the current price. An "out of the money" put is below the current price. Let's say you're willing to accept a 20% drop in price, so you buy puts that are 20% out of the money. If your stock stays above the strike price, the put will expire and the premium you paid for the contract will be lost. But if the stock craters, exercising the puts limits your loss to 20%.

Of course, puts cost less the farther they are out of the money. The cost of the contract increases as the strike price moves higher. They will also be more expensive for a longer term expiration date. Short term out of the money puts can be relatively inexpensive. Long term at or in the money puts come with a higher cost. For example as of June 2nd, 2015, the SPY, the ETF that tracks the S&P 500 closed at $211.36, if you owned 100 shares the position would be worth $21,136. If you were concerned about a serious market drop of more than 10% you could purchase one 190 put to cover the 100 share position. The 190 put that expires in June, in 18 days, would cost $9 or $0.50 cents per day, the July put that expires in 45 days would cost $52 or $1.16 per day. If you wanted longer term protection the January 2016 190 LEAP would cost $476 or $2.43 per day. Short term out of the money puts are not that expensive during normal market conditions. Of course, prices vary between securities, timing and with other factors. 

Meanwhile, selling call options can also be a way to produce some extra income from your holding and provide a small amount of downside protection. The downside protection when you sell a call option is limited to the premium you receive for your call. Selling an out of the money call will give your stock some room to move up in price and will also provide some income. You can sell an in the money call if you want downside protection, but remember when you do that you are giving someone else the right to buy your stock from you at the strike price and you have the obligation to deliver it.

Another way to get some protection is to combine the two strategies. You can sell a call option and use the premium received to purchase a put option.

This strategy, when tied to a stock position, is known as a collar. Having a collar around your stock will limit both the upside and the downside. The collar can be as "tight" or "loose" as you want according to the strike prices you select. You don't have to collar the entire position if you want unlimited upside on some of it, and you can always collar half the position or any amount you are comfortable with. More information on how these work can be found here.

Does this strategy work? A ETF study by Edward Szado and Hossein Kazemi at the University of Massachusetts using the Powershares QQQ ETF (QQQ), which tracks the NASDAQ 100 index, found that by purchasing a six month put option that was 8% out of the money and selling one month call options that were 2% out of the money, superior results were obtained over a buy and hold strategy during the 1999 to 2008 period.

 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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