Best of the Week
Most Popular
1. US Housing Market House Prices Bull Market Trend Current State - Nadeem_Walayat
2.Gold and Silver End of Week Technical, CoT and Fundamental Status - Gary_Tanashian
3.Stock Market Dow Trend Forecast - April Update - Nadeem_Walayat
4.When Will the Stock Market’s Rally Stop? - Troy_Bombardia
5.Russia and China Intend to Drain the West of Its Gold - MoneyMetals
6.BAIDU (BIDU) - Top 10 Artificial Intelligence Stocks Investing To Profit from AI Mega-trend - Nadeem_Walayat
7.Stop Feeding the Chinese Empire - ‘Belt and Road’ Trojan Horse - Richard_Mills
8.Stock Market US China Trade War Panic! Trend Forecast May 2019 Update - Nadeem_Walayat
9.US China Trade Impasse Threatens US Lithium, Rare Earth Imports - Richard_Mills
10.How to Invest in AI Stocks to Profit from the Machine Intelligence Mega-trend - Nadeem_Walayat
Last 7 days
Gold Golden 'Moment of Truth' Is Upon Us: $1,400-Plus or Not? - 18th June 19
Exceptional Times for Gold Warrant Special Attention - 18th June 19
The Stock Market Has Gone Nowhere and Volume is Low. What’s Next - 18th June 19
Silver Long-Term Trend Analysis - 18th June 19
IBM - Watson Deep Learning - AI Stocks Investing - Video - 18th June 19
Investors are Confident, Bullish and Buying Stocks, but… - 18th June 19
Gold and Silver Reversals – Impossible Not to Notice - 18th June 19
S&P 500 Stuck at 2,900, Still No Clear Direction - 17th June 19
Is Boris set to be the next Conservation leader? - 17th June 19
Clock’s Ticking on Your Chance to Profit from the Yield Curve Inversion - 17th June 19
Stock Market Rally Faltering? - 17th June 19
Johnson Vs Gove Tory Leadership Contest Grudge Match Betfair Betting - 17th June 19
Nasdaq Stock Index Prediction System Is Telling Us A Very Different Story - 17th June 19
King Dollar Rides Higher Creating Pressures On Foreign Economies - 17th June 19
Land Rover Discovery Sport Tailgate Not Working Problems Fix (70) - 17th June 19
Stock Market Outlook: is the S&P today just like 2007 or 2016? - 17th June 19
US China War - Thucydides Trap and gold - 16th June 19
Gold Stocks Bull Upleg Mounting - 16th June 19
Gold Price Seasonal Trend Analysis - Video - 16th June 19
Fethiye Market Fruit, Veg, Spices and Turkish Delight Tourist Shopping - 16th June 19
US Dollar Gold Trend Analysis - 15th June 19
Gold Stocks “Launch” is in Line With Fundamentals - 15th June 19
The Rise of Silver and Major Economic Decline - 15th June 19
Fire Insurance Claims: What Are the Things a Fire Claim Adjuster Does? - 15th June 19
How To Find A Trustworthy Casino? - 15th June 19
Boris Johnson Vs Michael Gove Tory Leadership Grudge Match - Video - 14th June 19
Gold and Silver, Precious Metals: T-Minus 3 Seconds To Liftoff! - 14th June 19
Silver Investing Trend Analysis - Video - 14th June 19
The American Dream Is Alive and Well - in China - 14th June 19
Keeping the Online Gaming Industry in Line - 14th June 19
How Acquisitions Affect Global Stocks - 14th June 19
Please Don’t Buy the Dip in Nvidia or Other Chip Stocks - 14th June 19
A Big Thing in Investor Education is Explainer Videos - 14th June 19
IRAN - The Next American War - 13th June 19
Boris Johnson Vs Michael Gove Tory Leadership Grudge Match Contest - 13th June 19
Top Best VPN Services You Can Choose For Your iPhone - 13th June 19
Tory Leadership Contest Betting Markets Forecast - Betfair - 13th June 19
US Stock Market Setting Up A Pennant Formation - 13th June 19
Which Stocks Will Lead The Cannabis Rebound? - 13th June 19
The Privatization of US Indo-Pacific Vision - Project 2049, Armitage, Budget Ploys and Taiwan Nexus - 12th June 19
Gold Price Breaks to the Upside - 12th June 19
Top Publicly Traded Casino Company Stocks for 2019 - 12th June 19
Silver Investing Trend Analysis - 12th June 19
Why Blue-Chip Dividend Stocks Aren’t as Safe as You Think - 12th June 19
Technical Analysis Shows Aug/Sept Stock Market Top Pattern Should Form - 12th June 19
FTSE 100: A Top European Index - 12th June 19
Gold Surprise! - 11th June 19
How Forex Indicators are Getting Even More Attention in the Market? - 11th June 19
Stock Market Storm Clouds on the Horizon - 11th June 19
Is Your Financial Security Based On A Double Aberration? - 11th June 19
What If Stocks Are Wrong About Interest Rate Cuts? - 11th June 19
US House Prices Yield Curve, Debt, QE4EVER! - 11th June 19
Natural Gas Moves Into Basing Zone - 11th June 19
U.S. Dollar Stall is Good for Commodities - 11th June 19
Fed Running Out of Time and Conventional Weapons - 11th June 19
Trade Wars Propelling Stock Markets to New Highs - 11th June 19
Best Travel Bags for Summer Holidays 2019, Back Sling packs, water proof, money belt, tactical - 11th June 19

Market Oracle FREE Newsletter

Gold Price Trend Forecast Summer 2019

How to Protect Your Portfolio with Stock Options Insurance Policy

InvestorEducation / Learning to Invest Nov 02, 2010 - 07:43 AM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleLarry D. Spears writes:If you don't deal a lot with stock options in your investments, you probably don't realize just how versatile options actually are.

In fact, stock options can be used:


•As a low-cost way to speculate on expected price movements.
•To generate some added income on stock holdings.
•To hedge against market reversals.
•And even as a form of "insurance" - when used to "lock in" gains on profitable positions, protecting those profits against such stock-market reversals.

Using Options as "Profit Insurance"
The latter strategy typically involves buying "at-the-money" (ATM) put options on your "long" stock positions. This creates a situation akin to an "insurance policy" in that your profit on the put options will offset most - or even all - of the erosion of your paper profits or even the outright loss on your stock, should stock prices turn lower during the life of the option.

Such hedges have particular appeal when stock prices have made a nice move higher - as they did in September and October. What's nice is that they give you a strategy option other than just "cashing out." They enable you to remain invested and play for the continuation of the upward move without risking too much of the profit you've already made.

The only problem is that dramatic price moves - whether up or down - tend to increase the market's perception of potential risk, causing option premiums to rise sharply. This makes the purchase of such "insurance" extremely expensive.

For example, on only a moderately volatile stock, an at-the-money put option with two months of life left currently costs around $500 for each 100 shares. That means the stock price would have to fall more than $5.00 a share before the insurance provided by the put would kick in.

Fortunately, there is a solution for this problem - a way to structure an option hedge that will give you virtually instant downside protection, and do so at little or no cost.

What you do is buy the protective at-the-money put, as in the basic strategy, and simultaneously sell (or "write") both a deep out-of-the-money (OTM) put and an out-of-the-money call option.

The sale of the put creates a bearish spread that will insure your stock position down to the strike price of the put you sell, offsetting any drop in the price of the underlying shares.

The sale of the call brings in enough added money to offset most or all of the cost of the put you buy for protection, while also allowing you to pick up a limited amount of additional profit should your concerns prove unfounded and the stock price continue to rise.

The position carries no additional margin requirement because the stock you hold "covers" the call you sell, and the at-the-money put you buy as insurance covers the put you sell.

A Case Study With Cummins

If you're not entirely familiar with options and their terminology, a couple of examples should help clarify how to structure the trade and explain how the strategy works.

[For simplicity - and to make it easier to calculate the potential trade outcomes - we'll use a 100-share lot of stock and single options in our examples, all based on actual prices available on Friday (Oct. 29).]

Assume you sold a couple of unprofitable positions in late December 2009 in order to take a tax loss, replacing one of them by purchasing shares in Cummins Inc. (NYSE: CMI), one of the world's largest makers of diesel and clean-burning natural gas engines (and a Money Morning "Buy, Sell or Hold" recommendation earlier this year). Your assumption was that industrial and manufacturing companies, which had been hard hit during the 2008-2009 downturn, would benefit most during any economic rebound in 2010. At the time, CMI was priced at $45.86 per share, meaning 100 shares would have cost you $4,586. (For the sake of clarity, we'll ignore the modest commissions in our examples.)

Although the 2010 economy proved to be less robust than hoped for - and the overall markets suffered a sharp pullback from April through June - prices rebounded nicely during the early autumn, with Cummins among the market leaders. In fact, by late October, it had climbed to near $95 a share, up more than 105% on the year.

The question you now must ask yourself is this: Do you believe that there will be enough of a continued improvement in the economy - albeit slow - to continue to benefit Cummins?

That was your belief, but then Cummins missed projections slightly when it reported third-quarter earnings last week and the stock dropped more than $5 a share.

In your opinion, that was an over-reaction - especially since the profits CMI reported were three times higher than a year earlier. But you didn't want to risk giving back any more of your hard-won profits, should the pullback continue. So you decided to buy an at-the-money $90.00 put option to lock in your gains.

However, a glance at the CMI option price tables showed that, with Cummins closing at $88.10 on Friday (Oct. 29), the January 90 put was priced at $7.40. That meant it would cost $740 to "insure" your 100 shares of CMI for just under three months - and the insurance wouldn't even pay off until the price of Cummins stock fell to $82.60 ($90.00 - $7.40 = $82.60).

That seemed a hefty price to pay for some short-term protection, but a look at some other option prices presented an alternative. The January 80 put was priced at $3.30 ($330 for the full contract) and the January 95 call option was quoted at $3.40 ($340). If, in addition to buying the January 90 put at a cost of $740, you also sold the January 80 put and the January 95 call, you'd wind up with a net debit of just $70 on the three-pronged hedge ($740 - $330 - $340 = $70).

Even better, you would be creating a position that:

•Locked in all of your current paper profit - plus an additional $190 - up to the $90.00 strike price of the put you sold ($90.00 - $88.10 = $1.90 x 100 = $190).
•Guaranteed you an additional profit of $120 (the $190 strike-price differential, minus the $70 debit), unless CMI pulled back more than 9% and fell below $80 a share prior to mid-January 2011.
•Allowed you to add more profits if your concerns proved wrong and CMI rallied again - at least until it moved above $95 a share.

To clarify these advantages, the following table shows all the possible outcomes for this strategy at any Cummins share price between $75 and $105 per share (assuming the positions are held until the option expiration on Friday, Jan. 21, 2011).

The strategy will work equally well across different time frames and with lower-priced stocks, though the amount of downside protection on shorter-term hedges will be reduced somewhat by the smaller premiums for the options.

A Low-Cost Hedge for a Hefty Gain

As an example, the table below shows the potential outcomes for a hedge on Family Dollar Stores Inc. (NYSE: FDO), a low-cost retailer that also did well in 2010's struggling economic recovery. Had you bought the stock at its year-end 2009 price of $27.83, you'd have been sitting on a profit of 65.9% as of last Friday (Oct. 29).

A gain that hefty is well worth protecting with a low-cost hedge.

Values in the table are based on Friday's FDO close at $46.17, with the January 46 put priced at $2.35, the January 42 put at $0.95 and the January 50 call at $0.80 - meaning the full three-pronged hedge cost only $60 to initiate and limited your loss to just $77 so long as FDO stayed above $42 a share prior to the January 2011 option expiration.

Obviously, if your concerns prove to be unfounded and the stock you're hedging resumes its upward course, this strategy will limit your future profits (unless you buy back the call you sold). However, if you have gains on an existing position - or are worried about a pullback on a holding that hasn't yet made an upward move - this strategy can be a highly effective means of protecting yourself.

And depending on the strike prices and premiums of the out-of-the-money options you choose to sell, you can get that protection at virtually no cost.

Actions to Take: In a market as uncertain as this one, it pays to think and invest defensively. Two moves in particular are worth considering.

First, in cases where you have a big profit in a stock - but want to keep holding it - consider the stock-option "insurance policy" outlined in this report.

And, second, take some time to look back through Money Morning's "Defensive Investing" series for other defensive strategies that are appropriate for this market.

[Editor's Note: Article author Larry D. Spears is an options expert. A veteran journalist and longtime chronicler of the global financial markets, Spears has also written several books on financial topics - including the options-strategy primer: "Commodity Options: Spectacular Profits With Limited Risk." In another recent contribution to Money Morning's "Defensive Investing" series, Spears illustrated how writing covered call options can increase your cash flow and provide added protection for your long-term stock positions.]

Source : http://moneymorning.com/2010/11/02/...

Money Morning/The Money Map Report

©2010 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules