Insurance is important to us, how about insurance for our stocks/portfolio?

Buying options to protect a stock is like buying insurance to protect ourselves. Options is very similar to insurance. When we buy an options, we are acting as the insurance policy owner. We pay premium to the insurance company to get insured. When we sell an options, we are acting as the insurance company. We collect premium from the policy owner periodically.

While selling options (not selling naked but defined risk trade) is a good strategy for income, we cannot ignore the importance of buying options to protect our stocks or portfolio. We are not talking about buying far OTM options to speculate because a lot of time, buying far OTM options will always become the income of the options seller as the OTM options has high probability to expire worthless.

Let’s illustrate with a case study. Imagine Apple stock is trading at $120 now and pending an important corporate announcement next Friday. As a long term Apple stock investor, we understand the stock will drop tremendously if the news is negative or rise sharply if otherwise. As Apple stock holder, we can choose to hold the stock and sail through the announcement and prepare to take the hit if the news is bad. Alternatively, we can sell the stock first and buy back later after the announcement. We may potentially miss a good run up if the news is good and we would need to buy back the stock at higher price later.

If we use options, we can buy a Put options by paying say $2 at $118 strike to protect our position.
1) If Apple stock drops to $100 after the announcement:-
a) Stock – We lose $20 ($120 – $100)
b) Put Options – We profit $16 ($118 – $100 -$2)
c) Our net position –  We lose $4 ($20 – $16)

2) If Apple stock drops to $50 after the announcement:-
a) Stock – We lose $70 ($120 – $50)
b) Put Options – We profit $66 ($118 – $50 -$2)
c) Our net position –  We lose $4 ($70 – $66)

3) If Apple stock rises to $140 after the announcement:-
a) Stock – We profit $20 ($140 – $120)
b) Put Options – We lose $2 (Put Options OTM and become worthless, we lose our premium paid)
c) Our net position –  We profit $18 ($20 – $16)

4) If Apple stock rises to $180 after the announcement:-
a) Stock – We profit $60 ($180 – $120)
b) Put Options – We lose $2 (Put Options OTM and become worthless, we lose our premium paid)
c) Our net position –  We profit $58 ($20 – $16)

It is obvious that adding a put options into our stock or portfolio will cap our losses (in this example to $4) regardless how sharp the stock drops but it does not cap our profit potential. If you have not consider to learn options yet, I hope this article can intrigue your interest to learn options now. 🙂

 

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