Using Options to Play Defense in a Scary Market

A variety of strategies are available to help investors rein in risk amid the current downturn

Forget everything you may have heard about options being too complicated for the average investor to understand or too risky. With the stock market delivering a virtual cascade of brutal sell-offs since mid-September, there are some fairly conservative ways to deploy options as a form of insurance, much like the policy you'd buy to cover, or at least limit, losses on a house that's in the path of a hurricane.

And because, at this point, you're buying insurance with the hurricane already in full swing, expect to pay a hefty premium for that protection, says Don Montanaro, founder and chief executive of, an online investing community that offers a menu of investor education tools.

Although the cost of protection has tripled in some cases as volatility in stocks has surged, only with time will we be able to gauge whether the current prices are fair or overpriced due to fear, he says. Over the past six months, the market has moved more than what option premiums have implied, "so they turned out to be cheap relative to what the market did," says Brian Overby, senior option analyst at TradeKing.

"You can tailor your insurance policy to meet your needs and desires and whatever your market prediction is. There's a tremendous amount of flexibility within options to find that deductible and…find the levels of risk you're willing to take and put borders around that," says Montanaro. Given how turbulent the market is and how little visibility there is about where it's headed, people shouldn't be holding a lot of money in investments without having insurance, he adds.

Starting Cautiously

Let's start with the basics. You can trade two types of options—calls and puts—depending on whether you have a bullish or bearish view of the market or of an individual stock. Buying a call gives you the right, but not the obligation, to buy the underlying stock if the price reaches or moves above the strike price by the time the contract expires. Buying a put entitles, but doesn't obligate, you to sell the underlying stock at the strike price if the stock has hit or gone below that level at expiration. An option contract typically represents 100 shares of the stock and expires on the third Friday of the month.

Option experts recommend that novices start by selling a covered call on a stock they own and still like even though the price has dropped from where they bought it. If you believe the stock will continue to trade sideways with no big gains anytime soon, you would sell a covered call at a strike price perhaps 10% higher than where the stock is trading, or high enough so you won't feel bad if you have to sell it. The premium you collect lowers your cost basis for owning the stock, and "the worst that can happen is you'll have to sell your stock to whomever you sold the call to at some profit," says Montanaro. Selling covered calls gives you a chance to see how the price of an option reacts to small moves in the stock and how the price comes down over time, says TradeKing's Overby.

As long as you continue to own the stock, you can repeat this process over and over until you no longer need the stock to rebound all the way to the price you paid for it in order to break even, since you've made money on the premiums, says Montanaro. In the current environment, the premiums have been fairly meager because stocks keep falling, so not many people are looking to buy covered calls above a certain price, says Overby. Just remember to factor the commissions on each trade, which can vary from 75¢ to $15 per option contract, into your profit and loss calculations, he cautions.

Chicago-based Web site optionsXpress (OXPS) offers a trade probability calculator that lets you analyze a trade, shows you what your return could be on that trade vs. the cost of your investment, and gives the probability of the stock moving above that strike price in the future. That allows you to decide which risk/reward parameters you want to trade, says David Fisher, CEO of optionsXpress. The Web site also features a covered call screener that helps you scan the marketplace for the best opportunities, based on certain criteria, such as a favored sector or a specific return you want to earn, he adds.

Stretegies With Puts

Premiums on puts, which buy you downside protection, are understandably much higher than they were a year ago. That makes it worthwhile for relatively inexperienced option traders to take their strategy up a notch by buying what's known as a vertical spread instead of a straight put, as a way to reduce the cost of protection, says Overby. An investor bearish on a particular stock would buy a put at a strike price that represents the level of loss he's willing to take, while at the same time selling a put at a lower strike price that he doesn't believe will be breached. Both puts have the same expiration date. The premium the investor earns on the lower-priced put reduces his cost of buying downside insurance but also limits the payout from the protection.

For example, if you're willing to take only a $10 loss on a stock trading at 100, you would buy a put at a strike price of 90 for $10. If you doubt the price will fall below 70, you would sell a put at a 70 strike for $3, reducing the cost of your protection to $7 from $10 a share. That entitles you to sell the stock at 90 all the way down to 70. If the stock is at 70 or below when the option expires, however, you'll have to buy someone else's stock at 70, even if the stock has dropped to 50.

Limiting your payout to $20 a share on a stock trading at 100 would cover your loss in most bear markets, which typically go down 15% to 25%, says Jim Bittman, senior instructor at the Options Institute at the Chicago Board of Options Exchange (CBOE). But with the Dow Jones Industrial Average more than 54% off its October 2007 peak, this is no ordinary bear market. Still, given how hard it is to predict when markets will move, he says he'd prefer to save on the premium by taking his chances on a limited price decline. Vertical spreads are taught at the end of a beginners' option class, so they're not for a complete novice, but they can be understood by people familiar with the very basics of option trading, he says.

Spreads With Calls

You can also use a vertical spread if you have a bullish outlook, using calls instead of puts with the same expiration date. This is a smarter strategy for those sitting on the sidelines, providing a way to take a long position at a fraction of the cost to buy shares of the actual stock, says Tom Sosnoff, president of thinkorswim Group (SWIM), the online option broker that TD Ameritrade (AMTD) announced it was buying in January. "If used correctly, the option world allows you to define your risk, increase the probability of success, and use less capital," he says.

In a bull vertical spread, you simultaneously buy an in-the-money call and sell an out-of-the-money call at a higher strike price. You can then close out your position at a profit once the stock has moved to your target level before the options expire, he says.

Given how quickly the stock market has deteriorated over the past two months, investors should have a price target, not necessarily a time duration, in mind, Sosnoff says. He notes that investors have to look at directional trades on a price-level basis right now, as things move so quickly in today's markets.

What Expiration Date?

The volatility of the underlying stock should determine how far out to go in terms of an expiration date on an option, says Overby. It's better to stick with relatively short durations of one to three months, since the insurance is useless if the stock moves beyond the strike price, either on the up or downside, he says. For the large bank stocks, some people are choosing March options instead of the April expiration, because a lot could happen in the next two weeks before the options expire, given the government's current "stress testing" of companies in the industry, says Overby.

Alan Medvin has become an aggressive option trader in the year and a half since he joined TradeKing. If not for options, he says, he probably would not have invested as much as he has in stocks. "It's a lot easier to limit your risk using options than if I were only buying stocks," he says.

He emphasizes the difference between trading naked puts vs. naked calls ("naked" refers to an option trade in which the investor does not own shares of the underlying stock). Selling naked puts is a more conservative strategy than buying the stock, since you're collecting a big premium. It's the same premium you'd get by selling a covered call if you own the actual stock, but it requires less capital, he says. To minimize the risk of having someone exercise a naked put he has sold, he targets stocks with good balance sheets, little debt, and that are trading close to their cash on hand divided by the total shares outstanding. "That puts a floor on my trading losses," he says.

Taking Losses

But he's gotten burned by options, too. Last September, when U.S. Steel (X) was trading at 72, he sold two $65 puts with an April 2009 expiration for $10 a share. When the stock broke below 65 and continued to drop, he bought two of those same puts for $26.73 on Oct. 8, when the stock was at 51, closing out his position for a loss of $16.73 a share. Then he sold a third put for $21 per share a day later, with the stock at 53, and covered that one in early December by buying a put for $30 when U.S. Steel was trading at 28, for a loss of $9 a share.

"All in all, a pretty bad trade, but by using options, the outcome was better than if I had just owned the stock," Medvin wrote in an e-mail. "Had I bought 200 shares of U.S. Steel at 72 and sold it when it fell to 51, I would have lost $21 per share. With options, I had essentially the same exposure and lost only $16 per share."

Overby urges people always to be ready and willing to buy back short options early when they see the market moving against them. In his paper, Top Ten Mistakes New Option Traders Make, he says his rule is that if he's able to keep 80% or more of the premium he got for selling the option, he'll buy it back immediately.

Times to Hold Back

He also advises investors not to sell covered calls during earnings season until after the impact of an earnings announcement has been absorbed by the market or if there's a dividend date approaching, since those events tend to boost volatility in the underlying stock, making the premiums on options more expensive and more enticing to beginning option traders who don't understand the downside risk. "I'd rather see [beginners] buy a protective put on a stock they like. It does the opposite of a covered call," he says. "You'd have limited and known downside during earnings and you have unlimited upside."

A cashless collar is another way to reduce the cost of buying downside protection on a stock you own and are worried may fall. That entails selling a call at a strike price above where the stock is trading and using the premium to buy a put at the lowest strike price at which you'd be willing to sell if the stock falls considerably lower. This is often the only way to persuade some people who balk at the price of downside protection to buy it, according to Darin Pope, chief investment officer at United Advisors in Secaucus, N.J. The only thing you give up is any upside in the stock above the higher strike price. Pope uses options only for clients with a large concentration in a single stock who refuse to pare their exposure because the stock has such a low cost basis and they don't want to realize big capital gains.

Investors can also buy more general protection against an entire portfolio instead of just single stocks. If you've seen a number of stocks you own lose value but don't want to sell them and miss a possible rally, you would buy a put on an index, such as the S&P 500, or on a couple of exchange-traded funds, says Fisher at optionsXpress. The protection may not exactly match dollar for dollar, because you're using an ETF, but it should be fairly close, he says.

Given the market carnage already witnessed—and the prospect of more to come—it's a good time for investors to expand their toolbox. For those still nervous about stepping out of their comfort zone, Sosnoff of thinkorswim says: "There's no truth to the notion that says the more complex a trade is, the riskier it is. In fact, I generally argue, the more complex a trade is, the less risky it is, because you're using all the tools, strategies, and products available to you."

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