Protecting Profit In Volatile Times with Protective Puts

Every longer term, bullish stock trader dreads the profit killing spike downs that can occur when unexpected bad news is released.

It is particularly painful to see profits quickly disappear after a long, slow grind up. Trailing stops is one way to protect your profitable stock positions. However, stops can knock you out of a position, and then the stock can rebound quickly without you.

There is a simple options strategy that can protect the downside in stocks, yet allow for the markets recent inherent volatility. The strategy is known as "Protective Puts".

This tactic involves simply buying one put contract for every 100 shares you own. This enables you to sell the stock at the Puts strike price regardless of how far the stock price drops.

There is no need to sell the stock at all; this strategy simply provides the ability to do so at the pre-determined price if you wish. Think of it as insurance, you pay an insurance premium that is good for the duration of the policy.

Here you are paying the premium for insurance as the Put's price. The upside profit for this tactic is unlimited as the stock price can theoretically keep going up. However, it's important to keep in mind that your profit will be reduced by the premium paid for the Put. It's easy to figure out your breakeven point for this method, simply add the amount you paid for the Put to the price you paid for the stock. Depending on what happens this can end up being a very insignificant price to pay for the protection provided, particularly in days like these.

Protective Puts are primarily used to protect gains. Here is an example of a stock situation where this strategy would have been wise to use (remember, these are examples only and the figures given are hypothetical).

Let's assume you bought 100 shares of Boeing (BA | Quote | Chart | News | PowerRating) stock at 79 when price broke the 50-day Moving Average back in April. You rode the stock up to the 86 range and your TA skills noted that the 200-day Moving Average was acting as strong resistance.

You believe that with the strength recently shown in Boeing it will just smash through the 200-day Moving Average so you don't just want to sell here. In order to protect the profits, you bought a June 85 Put in mid-May for $3.25 or $325.00.

As you can see, Boeing was smashed down off of the 200-day Moving Average, taking your profits with it. However, since you purchased the Protective Put, you could have sold the stock at anytime up to expiration at 85.00/share.

Every trader should have the Protective Put tactic in their toolkit during these times of high volatility.

David Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.