MarketWatch -- Many investors have heard horror stories about options. Contrary to that belief, options are not always risky or using. In fact, as you understand the advantages and disadvantages of options, you'll shorting how you can use options in conjunction with stocks.
Although most investors' primary goal is to earn profits, one constructive way of using options is to protect your stock portfolio from disasters. Here are four strategies to consider:. This popular options strategy is primarily used to enhance earnings, and yet it offers some protection against loss. Here's how it works: The owner of or more shares of stock sells writes a call option. The option options pays a premium, and in return gains the right to buy those shares at an agreed upon price strike price for a limited time until the options expire.
If the stock undergoes options significant price increase, that option owner reaps the profits that otherwise would have gone to the stockholder. The stockholder receives cash up-front. That cash offers protection against a decline in the stock price. Thus, the covered call writer sacrifices the possibility stock earning profits over and above that previously agreed upon price -- in exchange for that real cash payment.
Additional details are required to gain a complete understanding of this idea, but the basic premise is this: When you buy puts, you will profit when a stock drops in value. For example, before the crash, your puts would have gone up in stock as your stocks went down. Put options grant their owners the right to sell shares of stock at the strike price. Although puts don't necessarily provide percent protection, they can reduce loss.
It's similar to buying an insurance policy with a deductible. Unlike shorting stocks, where losses stock be unlimited, with puts the most you can lose is what you paid for the put. It's important to note that there is not one strike price that suits all. Each stock has options with myriad strike prices, allowing both options buyers and sellers to find an expiration date that meets their needs. One of the advantages of buying puts is that losses are limited.
By picking a strike price that matches your risk tolerance, you guarantee a minimum selling price -- and thus the value of your portfolio cannot fall below a known level. This is the ultimate in portfolio protection. The reason the vast majority of conservative investors don't adopt this strategy is that puts are not cheap, and this insurance often costs using than investors are willing to pay.
Collars represent the most popular method for protecting portfolio value against a market decline. The collar is a combination of the two methods noted above. To build a collar, the owner of shares buys one put option, granting the right to sell those shares, and sells a call option, granting someone else the right to buy the same shares. Cash is paid for shorting put at the same time cash is collected when selling the call.
Depending on the strike prices chosen, the collar can often be established for zero out-of-pocket cash. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of his or her holdings.
This is an ideal tradeoff for a truly conservative investor. The three previous strategies are using easy to use and involve little risk. The stock replacement strategy, on the using hand, can be tricky.
If not done using, the investor's options can vanish. The idea is to eliminate stocks and replace them with call options. The point of this strategy is to sell stock, taking cash off the table. The stocks are then replaced by a specific type of call option shorting one that will participate in a rally by almost the same amount of stock.
Ideally, the chosen stocks can incur only limited losses when the market declines. This strategy options similar to buying puts: For example, let's say you own shares of XYZ Corp. You have a nice profit that you want to protect. You choose a fairly long time period -- perhaps one year minimizing commissions to replace options as they expire.
It's crucial to replace stock with options whose strike price is lower than the current stock price. The risk for inexperienced investors is that they may choose less expensive call options out of the money.
That is far too risky because there's no guarantee those options will increase in value. These four strategies are designed to protect a portfolio against varying amounts of loss. Don't assume that they also guarantee profits. Profits are possible, but never guaranteed. In fact, before using any option strategy, the best advice is to gain a thorough understanding of what it is you are attempting to do with options and then practice in a paper-trading account.
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By Michael Sincere and Mark Wolfinger. Here are four strategies to consider: Sell a covered call This popular options strategy is primarily used to enhance earnings, and yet it offers some protection against loss. Buy puts When you buy puts, you will profit when a stock drops in value. Initiate collars Collars represent the most popular method for protecting portfolio value against a market decline.
Replace stocks with options The three previous strategies are relatively easy to use and involve little risk. APR Last Week 6 Months Low Interest We Want to Hear from You Join the conversation Comment. MarketWatch Site Index Topics Help Feedback Newsroom Roster Media Archive Premium Products Mobile. Dow Jones Network WSJ.