Using Options to Create a Cushion

They can limit your losses

In a bull market, no one cares about downside protection. Now, though, you may care a lot--and that's why it may pay to think about options. These instruments offer protection for a limited time, typically from one month to two to three years. Options can also be expensive, especially those with the longest terms, so they're not for everyone. Still, if you think your holdings will rebound but are nervous about being wrong--or if you're hesitant to sell for tax or other reasons--options may be for you.

One strategy for insulating your portfolio against sell-offs is to buy a put (that is, sell) option on a stock market index. When you purchase a put on an index, you lock in a specific value--say 8,200 for the Dow Jones industrial average. Because a put appreciates as its underlying index declines, it's possible to engineer it so that the profits on your options will roughly offset your portfolio's losses, depending on the index value you select and how closely your portfolio tracks the benchmark.

To get the most protection for the least expense, choose a strike price that's close to the index's current level. For example, a contract to insure against the Dow falling below 8,200 by Dec. 20 cost $370 on July 29 (table), vs. $3,020 to protect against the index closing under 11,000. Options prices are typically quoted as 1% of their actual cost, so you'll see these options listed at $3.70 and $30.20 instead of $370 and $3,020.

If the Dow falls to 7,200 by the time your option expires, a put that guarantees you a value of 8,200 will yield a $1,000 profit. Subtract the $370 you paid for the option, and you have $630 left. If you buy enough contracts to shield your entire nest egg, you can offset much of your portfolio's losses. Of course, if the index closes above 8,200, your option will expire worthless.

If you are heavily exposed to one stock and are concerned about sell-offs, put options can protect your downside while preserving your ability to profit from a rebound. Say you bought IBM (IBM ) years ago at $40 and want to keep it, because you think the stock is worth more than its current price of $71. To limit your risk, you can buy a put giving you the right to sell IBM for $65. The put that expires on Sept. 20 cost you $2.65 on July 29--which really means $265 per 100 shares.

The option's cost, known as a premium, reduces any profit you realize on the stock. But because the option guarantees you a $65 sale price, you'll be able to rest easy if IBM is hammered before the put expires. And if IBM soars, you simply keep your stock.

You can also earn some income while holding your shares by selling call options. Say you bought IBM at $65 and think it's worth at least $75. Sell a call giving the buyer the right to acquire your shares for $75 by Sept. 20. This will net you premium income--on July 29, this amounted to $2.50 a share. If IBM rises above $75, you'll be forced to sell. But that's not bad, since you'll realize a $10 gain on the stock, plus the $2.50 premium. That's a 19% return on your $65 investment.

If IBM stays below $75, the call will expire worthless since no one will want to buy your stock for $75. Once the option expires, you can sell new ones and collect more premiums. In a flat market, that may be your best hope for making money.

By Anne Tergesen

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