How to Use Put Options to Minimize Stock Investment Loss
An unprotected portfolio can be as dangerous as driving your vehicle without insurance. Hence it is important to hedge your longs with appropriate downside protection. Put options is a great way to minimize loss while still preserving the growth prospects.
Things You’ll Need
- Investment portfolio
- Brokerage account
- Basic options trading
Ways to Use Put Options to Minimize Stock Investment Loss
A put option gives you the right to sell the underlying security at the agreed upon strike price at a later date. So if your stock falls, you can close your put-option for a profit and offset your loss.
You can buy put option against the individual stocks that you own in your portfolio. You can also buy put-options against major indexes such as S&P 500, for general down side protection, or buy it against a selective index that better approximates your stock holdings. Tip: It is easier to buy put options against a tracking ETF (e.g. SPY) than against the index itself (e.g. S&P 500).
Depending on the worth of your portfolio and the premium you are willing to pay for put options (just like your insurance policy, put option comes with a cost), you should calculate the number of put contracts you need to buy. Each put contract gives you the right to sell 100 underlying security, so your total cost is (option premium * 100) + commission. Let’s illustrate with the example below.
Let’s say you bought 100 SPY for $90 each. To protect this $9000 investment, you would buy a put contract for selling SPY at $90, say 3 months into the future. If the contact costs $5 and commission is $8, your total put cost would be (5*100) + 8 == 508. So your total investment cost would be $9508. In other words, you would have paid 5.64% premium (i.e. 508/9000). So if your investment rises above $9508, you make a profit. On the other hand, if it falls below $8492 (i.e. 9000 – 508), you would claim your insurance policy.
If you don’t want to pay full premium for traditional put option, you can use bear-market-put-strategy to minimize the premium, essentially buying put option for the strike price and selling put option for a lower price. Your total premium is the delta between what you paid for the put option you bought vs. what you collected for the put option you sold.