March 26, 2008

Using Put Options to Hedge your investments

Often people will ask me what I think is going to happen in the market. Typically this question gets asked when the market is performing badly. I've said to people a number of times, if you have stock that you can't unload for tax purposes or because you simply don't want to, or perhaps you take a longer view of the economy and simply are a "buy and hold" type of person, you should use put options as a hedge. Invariably this statement is met with a look of bewilderment and confusion. Once I start to explain put options people simply think they are too complicated and zone out. With that said, I think this blog is a great place to explain the proper use of a put option as a hedge strategy.

A put option gives the owner the right, but does not obligate them, to sell a specific security at a specified price within a specified time. It really is like term insurance. When you buy a put option you pay a fixed price, typically much less than the underlying security, and that allows you to sell the security at that price. So let's see an example:

Shares of ABC security are trading around $100.00 a share and you already own 200 shares. You bought when they were around $70 a share and have made a very nice profit of $6,000.00. You want to protect that profit and are worried that the stock market is weak and your profit could be at risk. So you decide to buy some put options, as Billy recommends. You go out and you buy 2 put contracts; those contracts will cost around $10.00 per share and each contract consists of 100 shares, thus costing an overall $2,000.00.

The next day the market tanks and ABC is trading around $70.00 you have two choices, the first choice is complex and involves becoming short of the stock and buying to cover and profiting from the difference. If you are familiar with going short read the next section. If not, skip the next section and read below it for a simpler method of using put options.

You can exercise your put option which will make you "short" ABC 200 shares at $100.00 and you can re-buy to cover your position at $70.00, thus making a profit of around $6000.00. So for a $2,000.00 insurance policy you have protected your $6,000.00 Profit.

The simpler option is to simply sell the put option for a potentially large profit. Remember you bought the put option at $10 a share (2 contracts, 200 shares for $2,000.00). As the underlying ABC stock falls in value the put option rises in value. It is very likely that that options value could now well be over $40 a share. So now you can simply sell your put option for $40 a share and again you will make around $6,000.00 protecting your profits. It really is as simple as that and really works as insurance used in this manner.

Let's see what happens if ABC goes up instead of falling in value. ABC the next day goes up to $105 and the next day $110, for whatever reason you are no longer worried about the Stock falling in value you have 2 choices: 1 let the put option expire worthless, or, before the option expires simply sell the option to recover a portion of your insurance policy. If you were to sell it in a week and ABC had advanced in value you would be able to sell it for around $7.00 a share, 2 contracts, 200 shares and recapture $1,400.00 of your $2,000.00, thus your put option (insurance policy) only would have cost around $600.00.

When buying a put option the only money at risk is the premium for the option. In the case above $2,000.00. Good luck in the market and be safe in your investing.

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