Insure Your Portfolio Against Huge Losses using Put Options | The Motley Fool

a couple whose retirement is in doubt because they had too much of their portfolio in supposedly solid and safe companies. parents who no longer have the college money they were saving for their 16-year-old son, because they kept it all in the market instead of taking it out at least three years before they needed it. 60-somethings who need to come out of retirement because they can’t withdraw their already depleted portfolios.

It’s twice as hard to hear stories of loss because it could have been prevented, and much of the worry, stress, and loss has been prevented.

Reading: How to use put options as insurance

What lesson can we learn from the past to help protect our portfolios from future losses? There’s at least one easy step investors can take to protect themselves against future unknowns when the stakes are high: use options for insurance.

options are tools, not weapons Around the tomfoolery, options have generally received a polite rebuff. “Most investors,” the argument goes, “don’t need to use options to be successful throughout their lives.” which is true. “And most investors lose money on options.” which is not true when you use options the right way.

For those unfamiliar, options give the option owner the right to buy or sell an underlying stock at a fixed price on a specific date. Options were introduced to the public in 1973 by the Chicago Board of Options Exchange. they have enjoyed increasing transaction volume each year as people realize their value as portfolio tools.

I was skeptical of the options for several years, until I started learning more about them from assorted silly articles written around the turn of the millennium. Over the last eight years, and especially the last five, I have happily used options to manage public real-money portfolios, as well as my own portfolio. They have helped me get better bid and ask prices on strong companies, bet against some positions or hedge others, which can smooth returns, and protect myself against potential market downturns.

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Buying put options to insure your stock, especially when you have much of your savings parked in your portfolio, can be just as smart as having fire insurance on your home.

how put options work a put option gives its owner the right to sell a stock at a fixed price on a certain date. Buying a put option when you also own the stock is like buying insurance or protecting yourself against a possible downturn, because the put option guarantees you a fixed selling price on that stock, if you want, at a later date.

for example, if you own 1000 shares of yahoogleazon!, trading at $13, you could buy 10 put option contracts (each contract represents 100 shares) to insure your entire position against a further decline.

It could cost you around $3 per share to secure a $13 asking price (strike price) on your yahoogleazon! shares maturing in 7 months.

so even if yahoogleazon! dropped to $5 over the next 7 months, the owner of the put could sell at $13, for a net selling price of $10 after accounting for the cost of the put options.

yes yahoogleazon! declines in the coming months and you still believe in its long-term potential, you can sell your put options for a profit and still own the stock.

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On the other hand, if yahoogleazon! is $13 or more for July (let’s say it’s $18), your $13 insurance policy will no longer be worth anything. Like any insurance policy, it expires. still, he was hedged against the downside and still benefited from the stock as it rose.

There are secondary benefits as well. Knowing that your key stocks are secured with put options can make you comfortable enough to nibble on newly beaten opportunities you see. At the very least, with key positions secured, it won’t run for the hills and sell out at the worst times. and when the markets recover, you will participate.

when to use put options it is not cheap to secure large positions for long periods of time, especially in today’s volatile environment. but these days, that upfront cost can be dwarfed by losses you could avoid later.

Generally, you should consider put options as insurance for positions that are large or vital in your portfolio, or face more risk now than you originally assumed. Also, if you are preparing to sell a position in the next year or two, put options are a handy way to lock in a minimum selling price for your chosen sell date. you pay for the privilege, but from there everything is positive, without worrying about the disadvantages.

Use Options to Leverage Your Knowledge of a Stock I use options to leverage my existing knowledge of a stock’s valuation and the underlying business. There are many lucrative options strategies for stock-based investors, strategies that complement and enhance your stock portfolio, rather than compromise it. I am not a speculator or options trader. I am a stock-based investor who understands the power of options when used in conjunction with stock knowledge, and when used for risk management and to enhance returns in rising, falling or flat markets.

This article was originally published on October 1. 1, 2008. has been updated.

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