Stock Forex

One last use for options is a “hedge.” A hedge is like an insurance policy. You hedge to limit your downside.

Let’s say you just spent $10,000 and purchased 100 shares of stock at $100 each. You think the stock is low (either the company is really profitable or that the stock has gone down — hit a low). That’s a lot of money to have tied up. You have unlimited upside potential and all the time in the world because you actually own the stock. Your only risk is a dip in the price of the stock.

To ensure against a loss in your stock value, buy a $100 put, or even a $95 put (if you are willing to lose a little). Yes, you could put in a stop loss, at, say, $97 and only lose $300, but what about a drop to $70 wherein you could lose $3,000. The $100 put is, say, $2. One contract (controlling 100 shares—the same amount you own) would cost $200 plus commission. If you never exercise the put, that’s $200 out the window. You bought the stock hoping it would go up, and if it does your $200 ($2 put) goes down in value. Any increase in the value of your $10,000 investment will be offset by this loss. However, if the stock goes down, and I mean seriously down, this $200 will be money well spent. If the stock goes down to $80 (assuming this is still before the expiration date of the put) your put will be worth at least $20. It could be $22 to $25 depending on any time value still built into the put premium.

Think of this. You could sell the stock for $80 and also sell the put premium for $20. That’s $8,000 and $2,000 respec­tively. You’ve broken even. You see the insurance-against-loss aspect of this. You could lose $200 or at least have your profits offset by this amount, but you can make up all your losses with the proper put.

Two more ideas: the $95 put might be purchased for 25tf when the stock is at $100. One contract would be $25 plus commissions. This lower strike price and the corresponding lower put premium will let you buy a put further out (say 5 to 6 months) for a lower price. Your risk is $500 plus the put premium. Why $500? Because you’ve lost the amount between $100 for the stock and $95. 100 shares times $5 equals $500.

The $100 put is $2 and it’s only out one to two months. I usually buy the short term puts at the higher strike price (out one to two months and then reevaluate the situation: com­pany news, the stock price near the expiration date, et cetera) or further out puts below the strike price. They’re cheaper but also give you more time.

By looking at the company’s chart you can determine how much you want to spend, how much time you want to buy, and how much risk you want to hedge.

Combo

You could also buy a call with a $100 or $110 strike price. If you’re certain this stock is a winner, go ahead and buy the stock for $10,000, but spend $500 and purchase the $105 calls out two to three months. If the stock rises, you’ll see first hand how the riskier option plays produce the greater returns.