Protective Puts

With the market volatility we've seen over the past few years, more investors are recognizing the value of using puts as part of their everyday trading strategy.

For investors who put money in the volatile Internet or biotech sectors, the rewards can be enormous. But so can the risks--if the stock price rises instead of falls, this strategy may limit the upside potential by the cost of the put. By adding put options to their overall investment strategy, investors can better position themselves for any direction the market may head.

Using protective puts is simple and can be relatively inexpensive given the insurance value. For each 100 shares of stock you buy, buy one protective put at a strike price or two below the current market price. For example, if you buy a stock at $50, you'd buy either the 47.5 put or the 45 put. That way, if the stock plummets, you'll be able to sell the stock for close to what you paid for it.

On the other hand, if the stock jumps as you hope, you'll participate fully in the upswing less the small amount you paid for the protective puts. In this way, the puts act as an insurance policy.

Example

Let's look at AMGEN INC. (AMGN) trading at $50.66. It would take $5,066 to buy 100 shares. If you buy the shares, your downside risk, theoretically, is $5,066, with a potentially unlimited upside reward. Buying one protective put (to cover all 100 shares) limits the amount you can lose, should the stock fall.

To see how this works, consider the following:

AMGN trading @ $50.66
Buy	100 AMGEN INC @ $50.66	$5,066
Buy	AMGN OCT 45 Put @ $2.55	$255
Cost of Trade		$5,321

No matter how far the stock drops, as long as there is a protective put, the combined position will be worth $4,245.

Rolling Your Options

As the stock moves higher, you might want to roll the put up by selling the contracts you own and buying another one at a higher strike price. This way, you can lock in profit from the move higher. Too many investors have learned the hard way that what goes up rapidly can drop with equal momentum. So, if the stock jumps from $50 to $122, the 45 puts won't provide much downside protection. That's why it would be advisable to lock in profits by rolling the puts up to the 115 or 120 strike.