As a trader and as someone who coaches traders, I am aware that many people who think of themselves as investors are afraid of using options. Others who may be more experienced often fail to fully appreciate the risk in some strategies they are using and may lack the knowledge of how to reduce those risks with the use of options. In my book, "Trade Your Way to Wealth", I cover a variety of strategies and emphasize ways investors can reduce, and in some cases, even eliminate risk from certain trades.

What If You Could Protect Your Stocks From Huge Losses?

In this article, I'll discuss an extremely simple, yet very effective, way to reduce risk in stock ownership. Owning stock without protection is one of the riskiest strategies since the whole investment is at risk from the moment we enter a position. For example, if we buy 1000 shares of a stock at $20 a share we have $20,000 at risk and if the company disappears, so does our $20,000 unless we have done something to protect the investment.

Almost everyone insures their home, their auto, and their valuable possessions. We buy insurance to cover the cost of our own health care, and, recently, insurance has even become available to help defray the cost of health care for our pets.

Though we may not like paying the insurance premiums we recognize the value of protecting our larger assets. Surprisingly, though, even in the face of this knowledge, only the rare investor insures his own stock portfolio. I have spoken to many investors who saw the value of substantial portfolios drop by 40% or 50% after the tech bubble burst in the year 2000 following the amazing bull run. Even today, 8 years later, the Nasdaq 100 ETF (QQQQ | Quote | Chart | News | PowerRating) is only about half the value it reached in January of 2000.

Though the "buy and hold" strategy may work well over longer time frames, we would probably have a lot of trouble convincing investors who held onto Enron that buy and hold is the way to go.

As I write this piece, the markets have experienced another downdraft and many investors are, once again, feeling the pain. It is important to realize that a drop of 50% in the share price of a stock requires a gain of 100% just to get back to even.

A glance at the charts below of the recent performance of popular companies like Dell (DELL | Quote | Chart | News | PowerRating) and Starbucks (SBUX | Quote | Chart | News | PowerRating) demonstrates that stock prices of great companies can dive quickly.

The Solution

What can we, as traders and investors, do to protect ourselves from these kinds of losses? Of course, we could place a stop loss order at a price level where we would want to get out of a stock if the price went against us, but that is no guarantee that we would get the price where we set the stop.

Scenario 1: What Happens If Your Stock Drops at the Open

Suppose, for example, that we bought XYZ at $50 a share and are willing to risk 10%. We could set a stop loss at $45 and if the stock price drifted down to $45 our stop would be hit and we would probably be out of the position somewhere near that price.

However, what if XYZ drifted down to $45.40 by the close on a Tuesday and after the close the SEC announced it was investigating XYZ. Shortly thereafter, suppose the company announced that they were going to restate earnings for the last 2 years because it appeared that there may have been some manipulation by the company treasurer. Without a doubt, the stock price would gap day at the opening the following morning. Suppose it opened at $25 on Wednesday. Our $25 stop would have been hit and the stock sold. However, the sale price would be nowhere near our stop price of $45; we probably would have been closed out in the vicinity of $25. Our stop would have done nothing to prevent a 50% loss although we had designed it to limit the loss to around 10%.

What can we do to protect our positions from such devastation? One solution is the protective put. A put is an option contract where the buyer obtains the right (but does not have the obligation) to sell his stock for the strike price he chooses at any time until the option contract expires. In general, an option contract covers 100 shares of stock. In order to obtain the right to sell his shares at a pre-determined price, the put buyer pays a premium.

Scenario 2: An Example of How Protective Put Options Can Be a Form of Insurance

If we look at the earlier example of buying XYZ at $50 a share, we can see how a protective put might work. Let's say we bought 100 shares of XYZ in January for $50 a share. We checked the premium prices for puts with a June expiration and found that we could buy the June 50 put for $3.00. That means we could buy one contract for $300 (the premium is $3.00 per share x 100 shares per contract). Now we would have paid $5,000 for the stock plus the $300 premium to "insure" that we could sell XYZ anytime until the 3rd Friday in June for the same $50 a share we originally paid.

If the same scenario played out and the stock plummeted to $25 a share anytime before our puts expired in June, we could exercise the puts by calling our broker and telling him we wanted to exercise the puts and we would then sell our stock for $50 a share. Instead of losing $2,500 plus commissions as we would in the first example where we had the stop loss order in place, we would only be out the $300 premium we paid for the protection and the commissions.

The buyer of protective puts has many choices.

• He could decide to take on more risk himself and pay a smaller premium for the put protection. In our XYZ example, he could choose to buy a contract of the June $45 puts instead of the $50 puts and maybe pay only $1.25 a share instead of $3 a share for the right to sell the stock at $45 instead of $50 anytime before expiration. In that case, he would have the equivalent of a $5 "deductible"; he would be taking the first $5 risk himself and protecting the remaining $45.
  
  
• He could also choose to buy a longer or shorter expiration. Perhaps he would prefer to pay a little higher premium and buy puts that expire in September or maybe a lesser premium and get the April expiration.

In summary, all too many investors and traders enter positions with an eye to the profit side only and fail to account for the possibility of large losses. Stock purchases obviously can result in the acquisition of major assets that expose the investor to the risk of major losses. Great care should be taken to understand the risks in any investment and then a decision made whether to take any steps to reduce the risk. Protective puts can be an important device that is worthy of consideration particularly when investing in large stock positions and/or where the investor perceives a long term horizon.

Bill Kraft is a retired lawyer who has been a full time trader for the last 10 years. He is a traders' coach, editor of subscription services for Marketfn.com, and author of the best-selling book, "Trade Your Way to Wealth." His book discusses strategies that enable traders to learn ways to earn big profits with no risk, low risk, and measured risk strategies. If you are interested in Bill's book, click here.