One of the most common questions I get is how to protect stock positions with options. There are several ways you can use options to lower risk for stock investors as explained below.
Buying a Put Option to Protect Your Portfolio
Puts go up when stocks go down, so a put option can be purchased to protect a stock portfolio. This is done by simply purchasing a put for the stock that you own.
Using protective puts is less risky than shorting stocks since your maximum loss is the amount you paid for the puts while shorting stocks has unlimited risk!
Which Put to Buy
If you want to protect the stock from a large drop, then you could buy a put with a strike price that’s way below market value, which will be cheaper than a put with a strike price near market value.
But if you want to protect a stock from a smaller decline, a put with a strike closer to the market value gives more protection. (This is assuming your cost is near the market value; you are buying the put when you buy the stock.)
The closer the strike price is to the market price, the more owning the put option lowers your risk. Logically, the higher the strike price on the put option, the more the put option costs.
In other words, the better the insurance, the more it cost you.
How Does a Put Protect a Stock?
Here’s how the put option lowers stock risk: Since a put option gives the buyer the right, but not the obligation, to sell a security at a set price, you’ll be able to exercise the option to sell your stocks at the strike price on or before (for options in the U.S.) a given date.
Note that exercise date rules vary slightly between European options and U.S. options. For example, European options can’t be exercised early, but American options can be exercised early.
Option Time Decay WARNING
While this strategy sounds easy, options decrease in value simply due to time. This means that you are buying an asset that is almost certainly going to decrease in value while you own it unless stocks go down.
Here’s the thing: Bull markets last longer than investors expect they will. For example, the bull market that began in 2009 lasted over 10 years.
And the market climbs a wall of worry.
If an investor had begun buying protective puts 6 years into the bull market in 2015, for example, he could have seen his options become worthless from time decay.
Most investors using puts to protect stock portfolios, however, roll the put options forward to offset at least some of the time decay since time decay accelerates as an option’s expiration date nears.
Purchasing an ETF Put to Protect a Stock Portfolio
Let’s say you own a diversified portfolio of a dozen individual stocks. You can purchase a put on an ETF provide overall protection for a diversified stock portfolio.
This strategy works the same as the strategy described above, but instead of buying puts for each stock owned, ETF puts are purchased to protect shares in many different companies against an overall market drop.
Using Calls Options to Protect Stocks
A call option can be sold “against” a stock position. This reduces stock risk by lowering the basis, or cost, of the stock position each time a call option is sold.
For example, if you bought a stock for $50, and sold a $1.00 call option against it, your basis in the stock would theoretically be $49.
Let’s say the call option was out of the money and it didn’t get exercised. This allowed you to sell call options two more times at $1 each. At this point, your stock cost would theoretically be $47.
Covered Call Risk
Since the call option gives the buyer the right to purchase your stock at the strike price, the risk is that the stock can be “called away” at a price you don’t want to sell it for. If this situation occurs, fortunately, there are some strategies you can use that will allow you to keep the stock, such as rolling the call option.
The real beauty of selling calls against a stock position is that it can generate income in the .5 to 3% or more range per month, or up to 30% annually. More commonly, though, 1 to 2% per month returns are more the norm for less volatile stocks.
This passive income strategy can be a game changer, especially for retirees, when dividends and bond yields are so low!
But the problem is that covered calls are a bull market strategy. While they are an easy income strategy for stock investors, they do not protect the capital an investor has in stocks or stock ETFs.
A collar is a combination of a covered call and buying a put option. In other words, you’ve got a collar (limit) on both your loss and your gain.
With a collar, you get the income from selling the call option. Plus, your loss from owning the underlying stock is limited since you own a put option.
Options for Stock Protection Summary
Here are several ways to protect stock positions with options. It’s important to understand, however, that there are a few simple basics that everyone should know before trading options.
Understanding option pricing, potential risk, volatility and time decay, in particular, are all important concepts to grasp before trading options.