Stock jocks should be feeling pretty pleased: The Dow Jones industrial average is up 20% for the year, and equity portfolios are showing handsome returns. But success can breed anxiety. In the past few weeks, the market has hovered in the 4600 range and has suffered some scary one-day declines. If it tanks, your hard-won gains could fade. Yet if you take the profits, you'll owe a hefty chunk in capital-gains taxes, and worse, you could miss out if the bull continues to run.
Experienced investors can resolve this dilemma using stock options. But before you venture into this realm, make sure you've considered more basic ways to reduce risk. Diversification is one of the most fundamental ways to hedge, since the more sectors you're invested in, the more likely it is that some will go up when others go down. During high-flying times such as these, you could put more emphasis on stocks that tend to do well when the market declines, such as gold and energy. You might buy into mutual funds, such as Dreyfus' Comstock Partners Strategy fund and Rydex Ursa portfolio, that are designed to shine in down markets. Or you may simply want to move more of your assets into cash.
If such measures seem old hat and you've crafted a finely tuned portfolio you don't want to disturb, you ought to consider options, which are simply contracts allowing you to buy or sell 100 shares of stock at a fixed price by a specified date. In contrast with more basic strategies, options offer a precise way to protect a single stock, a specific sector, even a whole diversified portfolio.
Stock options are leveraged, so you need only put up a small amount of capital to produce gains substantial enough to make up for dramatic losses. But unlike other leveraged bets you can make by selling stocks short or playing index futures, your options losses can be limited to the premium you pay. Indeed, the prospect of unlimited losses, should prices go up, makes futures and short-selling too risky for many investors, says Scott Fullman, chief options strategist at Swiss American Securities.
Writing a covered call is an entry-level options play. Essentially, you sell another investor the option to buy your stock at a set price within a certain time period. You pocket the cash paid up front. (Of course, the exchanges act as intermediaries between buyers and sellers, and you have to pay brokers' commissions.) That set price is known as the striking price. Usually, you would pick one slightly above the stock's current trading price. The purchaser of the call hopes the stock price will climb, at which point that person could exercise the right to buy the stock more cheaply. So if your stock rises above the exercise price, it probably will be called away, and you'll have to sell it, unless you ante up again to buy back the option. But if the stock stays flat or declines, you keep the premium, along with your holding.
Here's how it might work: You own 100 shares of Motorola, trading at 763/4. After enjoying a 46% total return in the past year, you decide the stock has nowhere to go but down. So you write a covered call with a strike price of 80, allowing whoever purchases the call to pay you $80 a share for your stock. You pocket the $275 premium on the option sale. If the price climbs above 80, your stock will be called and you will sell, missing out on further gains. If the stock doesn't change or drops, you keep your shares and the premium.
CHEAP SHOT. Covered calls are considered a hedging strategy because the premium provides a cushion that can make up for losses when your stock declines in value. Volatile stocks make the best candidates, since you get a higher premium for them. But "selling a call option is not going to crash-proof your portfolio," cautions Bernard Shaeffer, president of the Options Institute, which publishes newsletters on options strategies.
If you really want to cover potential losses, you need to consider put options. Puts, the opposite of calls, are the right to sell a stock at a set price within a stated time frame. To protect your Motorola holding, you could buy an option to sell 100 shares of Motorola at 75 through mid-October, paying a $300 premium for that right. Then, even if the stock falls through the floor, you have locked in a selling price of 75. If the stock rises in price, your option expires and you'll be out the $300. You can trade options before they expire, but if you are hedging, you should leave them in place as long as possible.
Don't mourn an option that expires worthless. Instead, think of it as an insurance policy. Just as you buy collision coverage on a car while hoping you won't have an accident, you should buy put options as "crash protection," hoping you won't need them, says Richard Mikaliunas, who is in charge of marketing derivative securities at the American Stock Exchange.
Also, as with other insurance policies, you can negotiate a lower deductible if you're willing to assume more risk. For example, the longer the time period until the option expires (from one to seven months for standard options), the more expensive it is. A one- or two-month time frame is the most economical, but you can hedge for up to three years using long-term equity anticipation securities, or LEAPS.
You can also save money on put options by picking a low strike price--meaning you'll tolerate a large decline in value before selling the stock. The purest hedge is "at the money"--when the market value of the stock is the same as the striking price on the option. You can save on premium costs with an "out of the money" contract, where the stock value is higher than the striking price. The more "out of the money" you go, the less expensive the contract. For example, the same Motorola put with a striking price of 70 would cost $137.50.
If you're worried about a group of stocks, it may be easier to protect them all at once rather than individually. You can buy an option on a broad-based index or on an index that tracks a specific sector. If you're worried that your semiconductor stocks might crash, says Swiss American's Fullman, buy a put on the Philadelphia Semiconductor Index. Or if you're shielding a diversified portfolio of large-capitalization stocks, try the Standard & Poor's 100, a very liquid index that often matches holdings of individual investors.
Buying a put option on an index is similar to buying one on a stock, except index options are settled in cash. The put's value rises as the index value drops. If you do nothing and the index value declines, the exchanges exercise the option just before expiration and deposit the cash in your account.
STAY COOL. The biggest danger of hedging with stock options is that you'll grow so enamored of the potential for huge short-term gains that you'll start speculating, says Michael Braude, president of the Kansas City Board of Trade, which markets options on its Mini Value Line Futures contract as a hedging tool for individuals. The reason so many people grow to detest options and futures is not because they hedged but because they gambled and lost, he says.
Another danger is that you'll start trying to time the market. Once you buy a put, you'll have to watch options prices daily and learn to make quick buy and sell decisions. "They cause you to do the things a short-term trader does," says Shaeffer. Besides, he says, options can get costly: "You can get yourself into a psychology of having to keep buying new puts as old puts expire."
But even conservative financial planners say this may be a good time for smart investors to make a first foray into options. "Let's face it," says Daniel Masiello, a Staten Island (N.Y.) planner with American Express Financial Advisors Inc., "this bull market can't go on forever." And if the prospect of watching your gains erode is making you queasy, stock options could be just the tonic you need.