The stock market has had a long bull run and now is in danger of a major correction. We have written about how to deal with this possibility in our articles about safe investment niches, if you want to buy gold, and how you might switch your investment focus from growth to value. Today, we would like to look at another approach. How can you use options to protect your investment portfolio?
The Use of Options in Investing
Stock options can be useful in getting into an investment, providing a little extra income along the way, and protecting your investment. The tools of options trading are call and put contracts.
Buying Call Options
Call options can provide a cheap entry into a stock position. How do call options work? Our sister site, Options-Trading-Education.com discusses calls and puts.
A call contract gives the buyer the option to purchase the underlying equity which he will do if the equity price moves in the direction anticipated. A call contract confers an obligation on the seller (writer) of the call option to sell the underlying equity if the buyer executes the contract.
If you the investor expect that a given stock is going to go up in price you may choose to buy a call option on that stock. This option gives you the right to purchase the stock as the contract price, called the strike price, no matter how high the stock price goes. The beauty of the call option is that if the stock price does not go up or even goes down your losses are limited to the price of the options contract. This fact makes call options a valuable tool in a volatile market.
Selling Call Options
If you own a very stable stock it is possible to make extra money by selling call options on that stock. The buyer will believe that the stock price will go up and will pay you a premium to have the right to purchase from you when that happens. If you believe the stock will remain stable and not go up then you can sell call options and make extra money. In the end the option contract will expire, you will still own the stock, and you will make a profit. For more info on this idea, look at the Options-Trading-Education.com article, how to write a covered call.
Buying Put Options
This gets back to our original question. How can you use options to protect your investment portfolio? Do you think that the bull market has run its course and is in danger of a big correction? Do you also believe that not all stocks will fall and that timing a correction is difficult to do? Then you may wish to protect your gains in one or more stocks by buying puts. A put option gives the buyer the right to sell a stock at the contract or strike price no matter how far the price falls. If the stock does not correct you will have paid a premium for the contract and may consider that to be insurance against potential loss.