How can you protect your stock portfolio with put options?
In the long term, the best results are achieved with shares. On average, however, share prices are anything but stable. Certainly, in times of crisis, things can go very wrong. By buying put options, you can absorb the falls without having to reduce your entire portfolio.
Advantages of options
If you do not use options, and you expect a significant fall in the stock market, you will need to sell stocks in your portfolio. As soon as the stock market recovers, you will have to buy all the securities again, which only makes the broker happy. By using put options to protect your portfolio in case of an (expected) drop, you save a lot of money on transaction costs!
Before you can use this strategy, you should know what an option is. An option gives you the right, but not the obligation, to buy or sell a share at a fixed price. With a call option, you can buy a share at a fixed price and with a put option, you can sell a share at a fixed price.
Buying put options
Suppose the AEX is at 700 points, and you expect a drop to 670 points. Annoying, since all your Dutch securities will drop in value considerably. However, this is not a problem with put options. With a put option, you profit from price decreases whereby every decrease is a profit for you.
Buy a put option with a low strike price around the expected turning point (in this case 670 points). When the prices actually drop, you will obtain a good return, because you will be able to keep the price low. After this turning point, the prices will probably rise again: in this way you will come through the fall unscathed.
Of course, it is also possible that you were wrong; the prices will then rise. In that case, you pay a premium for the option and this equals your loss; the option is no longer usable. No problem, you expected a fall, and you have insured yourself against this risk by means of an option. Because the prices rise anyway, your return increases, and you earn money after all.
Be economical with put options
Do not try to protect your entire portfolio all the time. Put options are expensive! It is wiser to protect your portfolio when there is a specific reason for doing so. Think for instance of the issuance of new quarterly figures. Then consider, on the basis of historical figures, how far the price can fall. Options with a more favourable strike price are more expensive. By thinking strategically, you will achieve better results with put options.
Using an index option
It can also be attractive to use an index option to hedge your risk. This is especially a good option if you are trying to protect your portfolio against a general risk factor. After all, the risk of the collapse of a specific share due to disappointing results is hardly counteracted in this way!
If you want to protect your entire portfolio, it is more profitable to use a put option on an index than to take put options or each individual share. This is because you pay transaction costs for each share transaction.
Do you want to learn more strategies to make money with options? Read the article about making money with options!