Market Beat: Options for portfolio insurance
TRUCKEE, Calif. andamp;#8212; If youandamp;#8217;re an investor who is concerned about a decline in your portfolio due to either the broad market going down or to specific stocks selling off, you can consider using options to hedge your investments.If you purchase a put option, that gives you the right to sell your stock at a set price known as the strike price by a certain date which is known as the expiration date.The amount that you pay for an option is known as the premium. Purchasing put options to hedge is a lot like buying insurance on your house, you hope that you donandamp;#8217;t need to use it; it costs money, but can give some peace of mind knowing that you have it and that you are covered in the event of a disastrous market crash. If you buy a put option on a stock that you already own, that position is referred to as a protective put.The protective put is like insurance purchased on a stock holding to lock in gains or prevent further loss. This will increase the total cost basis in the stock by the amount of the put premium.For example if XYZ stock is at $50, and you have a cost basis of $25, you could theoretically buy a $50 put for $2 for six months. If XYZ were to go all the way to zero like Enron did, you have locked in a profit of $23 per share. Protective puts can also be purchased on indexes to hedge a portfolio. For example say you have a portfolio consisting of 20 stocks. Itandamp;#8217;s a simple matter to calculate the beta of your portfolio relative to a major index like the Sandamp;P 500. Then you can determine how many Sandamp;P 500 or SPY puts to buy to give your portfolio a hedge against a broad market decline, but not a company specific decline.If you are a bond investor with a portfolio of US treasury bonds and want to hold your bonds, but are worried about a rise in interest rates, you can purchase put contracts on a treasury index fund that will profit if rates rise and the value of the bonds in your portfolio falls. Options may not be suitable for all investors, yet can be very good portfolio management tools when used properly.Kenneth Roberts is a Truckee based Registered Investment Advisor. Ken has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm, and is currently a portfolio manager for Fusion Asset Management. Information on his money management service can be found at http://www.fusiontargetretirement.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.