Innovated Tips from Better Trades

An insurance policy for your stocks

With the market volatility we've seen over the past few years, more investors are recognizing the value of using puts as part of their everyday trading strategy.

For investors who put money in the volatile Internet or biotech sectors, the rewards can be enormous. But so can the risks--if the stock price rises instead of falls, this strategy may limit the upside potential by the cost of the put. By adding put options to their overall investment strategy, investors can better position themselves for any direction the market may head.

Using protective puts is simple and can be relatively inexpensive given the insurance value. For each 100 shares of stock you buy, buy one protective put at a strike price or two below the current market price. For example, if you buy a stock at $87, you'd buy either the 85 put or the 80 put. That way, if the stock plummets, you'll be able to sell the stock for close to what you paid for it.

On the other hand, if the stock jumps as you hope, you'll participate fully in the upswing less the small amount you paid for the protective puts. In this way, the puts act as an insurance policy.To see how this works, consider the following example.

Long 100 shares @ $87	$8,700
Long 1 put @ $4	$400

Total Cost	$9,100

Stock Price	Stock Value	Put Value (Loss)	Combined Value
$70	$7,000	$1,500	$8,500
$80	$8,000	$500	$9,000
$90	$9,000	$0	$9,000
$91	$9,100	Break Even Price	$9,100
$100	$10,000	$0	$10,000
$110	$11,000	$0	$11,000

No matter how far the stock drops, as long as there is a protective put, the combined value of your stock and option position will be worth $8,500.

Adjusting Your Options

As the stock moves higher, you might want to adjust the puts up by selling the contracts you own and buying more at a higher strike price. This way, you can lock in profit from the move higher. Too many investors have learned the hard way that what goes up rapidly can drop with equal momentum. So, if the stock jumps from $87 to $132, the 85 puts won't provide much downside protection. That's why it would be advisable to lock in profits by purchasing puts at the 125 or 130 strike.