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How to Use Options to Limit Downside


Now is a good time to provide some protection for both your portfolio and your individual stock holdings.

With the S&P 500 Index having run in nearly a straight line to gain some 9% year-to-date and the Nasdaq 100 up nearly 15% YTD and both now trading at their highest levels since May 2008, this is a good time to revisit how options can be used to provide some protection for both your portfolio and your individual stock holdings.

The simplest strategy is the purchase of put options to limit the loss incurred if the price of the underlying asset declines. This is known as a married put. Like most insurance, it comes with a cost that will have a drag on returns. But thanks to the leverage of options, a little money can buy you a lot of coverage.

The cost, like insurance, will of course depend on several factors -- for example, the term or amount of time. That's because the longer the policy, the lower the annualized cost. Also, the condition of the asset being insured must factor in. An analogy would be a house sitting on a fault line or a pack-a-day smoker, both of which will have higher insurance premiums. It will cost more to protect a stock like Baidu (BIDU) or Walter Energy (WLT) than Consolidated Edison (ED). Finally, you must decide what size deductible or out-of-pocket loss you're willing to accept.

An Apple Today

Let's use Apple (AAPL), because not only is it every writer's favorite ticker for showing an example, but it has also been a tremendous performer, up some 30% for the YTD. With Apple currently trading around $530 a share, you can buy the June $500 puts for around $20 per contract. Assuming you owned 1,000 shares of Apple, a reasonable amount of coverage might involve buying 10 of these puts, which would cost $20,000, or nearly 5.6% of your investment. Consider that your deductible. Of course, on an annualized basis (that is, if you rolled every quarter with all else being equal), that would end up costing 22% a year. So if you are looking for longer-term protection, use a longer-term option. For example, the January 2013 LEAP with the $500 strike costs around $44, which amounts to about 10.5% annually.

What do you get for that $20,000? First, understand that currently the delta of these puts is around 0.35, meaning that for each $1 move in the price of Apple shares, you can expect the value of the puts to move $0.35. So, at the moment, you only have 350 shares, or about one-third of your position protected. Depending on the timing, a 5%, or $27, decline in Apple down to $503 would equal a loss of about $16,000, as the puts will not have increased as much as the stock declined.

But since delta moves on a slope, meaning it increases as the options move further into the money, if Apple were to trade down to $500 in the next month or two, the puts would then have a delta of 0.50, meaning half of your position would then be protected. Full coverage -- or where the value of the 10 put options will increase on a one-to-one basis for each dollar decline in Apple stock -- will begin at around $450 per share, or around a 15% decline.

A Preemptive Strike Price

Now, how does that compare to simply selling off a portion of the shares to reduce risk and margin requirements? Selling 300 shares of Apple at $530 and staying long 650 if there was a 5% decline will result in the $17,550 drawdown from current levels, slightly less than the approximately $16,000 drawdown that would be incurred with the married put position. And you'd still have 650 shares, or be completely exposed to further losses.

The leverage provided by the put option will reduce the size of losses over the three-month period, and you still own that full 1,000 shares, meaning you retain the same upside potential should Apple resume its rally.

But also remember purchase of these puts moves your effective cost basis or purchase price up to $550 a share, or 3.7% from current levels. But for a stock that has shown the ability to gain 30% in two months and some 55% over the past 52 weeks, that might not too big a hurdle to jump.

The lesson: While leverage has its downside, by applying it in a preemptive fashion, you'll be well-positioned to reap the advantages of its upside.

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No positions in stocks mentioned.

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