If you’re planning to take one or two weeks off this summer to enjoy some nice and quiet beach and recharge batteries for the new season, then you’ll probably want to consider buying some insurance to guarantee the peace of mind you’re looking for.
But, unlike what you’re thinking, I’m not really referring to travel protection. Not that it shouldn’t be considered but I’m thinking on something really different – a protection plan for your stock holdings. Yes, that’s right! Even though no insurance company would be willing to protect you from stock market risks, there is a way of getting it out of the stock market. By using stock options you can buy a simple protection plan for your stock holdings and avoid spoiling your vacation. Do you remember the summer of 2011? Well, it was one of the most volatile periods ever. Between July 21 and August 8, the Dow retreated 1,915 points, a loss of 15pc in just two weeks.
To avoid this kind of unpleasantness, to say the least, you may protect your portfolio with some put options. These act like insurance. You pay the premium up front and in case something goes wrong with your underlying asset, you receive the insurance. Of course you may just close all your stock holdings before going in vacation but that may not be optimal. By closing a position you may become liable for capital tax gains and you won’t enjoy the upside potential the stocks may still command. A put option saves you from both situations.
When you buy a put option on a stock you already own, you’re building a strategy that is known as protective put. You may chose an option with any expiration date and strike price depending on your goals but you need to purchase options in the same proportion as shares owned. For each share you own you should buy one option, or for a typical contract with 100 options you should have the proportion of 1 contract for 100 shares.
The protective put will cost you the premium you pay for the options but you still enjoy full upside potential on your stock. If the stock rises, your option expires worthless but you enjoy the profit from the rising stock.
Let’s think on an example. Suppose you own 1,000 shares of Caterpillar Inc., which is currently trading at $85.53. Your portfolio is worth $85,530.
Put options expiring on August 16 with strike equal to $85.00 are trading at $1.91. In order to get protection for the whole portfolio you need to purchase 1,000 options (or 10 contracts) for a total premium of $1,910. This represents 2.23% of your portfolio, which isn’t negligible but may worth each cent you pay for it.
Let’s now suppose two possible outcomes: one in which the stock rises 15% and other in which the stock declines 15%. For a stock like Caterpillar, a change of 15% in such a small period like your vacation may seem exaggerated but let me tell you that in 2011 CAT lost 26% during the same period the Dow lost 15%, in just two weeks between July and August.
In the first situation the stock rises to $98.36. At maturity date, your put options are worthless and you will end losing the premium. Your profit from holding the stock amounts to $12,830 but the option subtracts $1,910 from it. You would have been better if no insurance was bought but you still gain $10,920.
In the second situation, the stock declines 15% to $72.70. Under this situation your options are worth $12.30 each at maturity, for a total of $12,300. After subtracting the options premium, you get a profit of $10,390 from the options. Instead of losing $12,830 (the loss you incur in the stock), you end with a loss of $2,440. The strategy effectively protected you.
With all this in mind avoid incurring in unnecessary risks during periods you’re not prepared for them as during a vacation. The best is to get the peace of mind you need to enjoy an unforgettable rest instead of ending with a massive headache. A protective put is what you need.
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