Trading Options as Insurance to Protect your Stock Portfolio

Of course, one of the greatest uses of put options is to insure the value of a stock or ETF portfolio. Although trading options as insurance is not a form of option selling, and therefore you will collect no premium, it ranks very highly in the safe use of options. If you are unaware of this technique, you will enjoy learning about it, especially in this day and age of volatile stock markets.

Here's how it works. Lets say you have 1000 shares of stock XYZ, which you bought at $50/share, as a major holding in your stock portfolio. You've had it for several years and it has increased in value to $60/share. You are happy because you have a nice paper profit. You are encouraged by the prospects for continued price appreciation in this issue, but you are nervous about the market in general, especially after the last few years of market turmoil. You decide to purchase a protective put to insure your stock against loss. You review the option chains for XYZ and notice that it has puts with strike values of 50, 55 and 60 for up to two years in the future. You like the idea of capping your downside risk at $55/share, so you purchase 10 contracts of the one-year-out XYZ 55 puts at $0.50. By doing so you have paid $500 plus commission to insure your holdings. Should XYZ drop precipitously to, say, $35/share, you have the right to "put" your shares to the options seller at $55. Many people protect their stock portfolio by buying protective puts; many more should consider doing so.

Many of you will recognize the protective put as one-half of the collar technique reviewed earlier. You will remember that in a collar you sell calls against stock you already own, and then purchase protective puts to limit your downside. So, once you insure your stock holdings with protective puts, consider selling calls against your stock for for income, maybe even enough to pay for your insurance.