How To Protect Your Stocks
by wallmann
They call this approach “MARRIED PUTS” and it’s appropriate because every
option contract is joined at the hip - “married” to a block of stock.
Remember, there are two types of stock option contracts. A “call” option
gives the owner the “right” but not the “obligation” to buy 100 shares of
the underlying stock at a specific price at a specific date in the future.
A “put” gives the owner the right to sell 100 shares at a certain price
and time. Essentially, call buyers are betting that the price of the stock
will go up and put buyers are betting that the price will decline. A
“premium” is charged for each 100-share contract and the premium
increases or decreases depending on a number of variables (demand, time,
stock movement, etc.)
When the indexes are moving higher we want to go long (buy) attractive stocks,
but we also want to protect ourselves against the strong chance that the
market will quickly change course and drag our stock down. We use put options
as “insurance” against that possibility.
Here’s how it works: Say you decide to buy 100 shares of XYZ Company at
40. You have invested $4000. At the same time, you buy one put contract
for XYZ with a strike price of 35 and an expiration date in mid-January.
If the overall market is moving higher and demand for puts is low, you
pay a premium of say only $1.50 per share, or $150 for the 100-share contract.
Your total investment is $4150 ($4000 for the stock and $150 for the option).
Let’s say that the market immediately turns against you and XYZ falls to
35. The value of your stock is now $3500. However, the decline has
actually increased the value of your put. The premium may now be $6.50, or
$650 for the contract. If you sell the stock and the option, you’ll pocket
$4150. Instead of taking a significant loss, you’ve broken even, thanks to
the put.
If, on the other hand, the stock soars to 50, the put will lose much of
its value. As the expiration date approaches, the premium will drop to 50
cents, maybe less. Again, you can sell your stock and option, and you’ll
bank about $5050 ($5000 for the appreciated stock and $50 for the
depreciated put). That’s a $1050 gain!
There are many ways to play. If your stock is moving ahead rapidly and you
don’t think you need the insurance, you can dump your put at a small loss
and let your stock ride. If you sense that your profitable stock run is
almost over, you can sell your shares and hang onto the put. If the market
reverses, the put will jump in value - more profits for you!
No doubt, you sacrifice some of your potential profit when you buy that
put. Insurance has a price. But you get peace of mind in knowing that you
can make a poor stock buy and avoid disaster. Until the market sorts
itself out, it’s an ideal strategy. Long term holders should consider buying
this “insurance” for their stocks, it’s crazy not too.
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Original Source: How To Protect Your Stocks