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HEDGING WITH OPTIONSMost investors invest their money in mutual funds or individual stocks. If you take the time to find good stocks that are worth owning, have you ever considered reducing the risk of stock ownership?
We all appreciate the profit potential of investing during a bull market, but as you know, periodic bear markets can be financially and emotionally devastating. There is something you can do about that. You can hedge (reduce the risk of owning) stock. This article describes two simple strategies to do just that.
FIRST, THERE ARE SOME BASIC FACTS THAT YOU MUST UNDERSTAND:
1. These strategies are not for everyone.
2. To gain the benefits of reduced risk, there is a cost. That cost can be either: reduced profits, or limited profits. Thus, if your goal is to earn the maximum possible profit from every investment, hedging is not for you.
3. The strategies do not eliminate all risk. They reduce risk.
STRATEGY ONE: WRITING COVERED CALLS
BENEFITS: Earn profits more often; reduce cost of buying stock.
NEGATIVES: Profits are limited.
THE IDEA: Sell one call option for each 100 shares of stock owned. Use the cash
· To provide a small cushion that eliminates or reduces losses if the stock price declines.
· As a steady source of income.
· To earn profits when the stock price is not rising. The cash premium becomes the profit.
By selling the call, you sacrifice the following:
· If a rally takes the stock price higher than the strike price when expiration arrives, your selling price for the stock is the strike price. You do not earn any profit above the strike price.
Thus, it is a trade-off: You get cash, but must accept limited profits.
STRATEGY TWO: BUYING PUTS FOR PROTECTION
BENEFITS: Excellent protection; investment is never worth less than a known value, unlimited profit potential.
NEGATIVES: Expensive, Increases cost of owning stock.
The idea: When you own a put option, you have the right to sell stock at a known price (strike price). As long as you own the put option, your have complete protection below the strike price. Translation: No matter how low the stock price may decline, the put owner can always sell that stock at the strike price.
· Buying puts is almost always expensive and it becomes difficult to earn profits from your investment. Translation: If you pay $250 for one put option, the stock must rise by more than $2.50 per share during the lifetime of the put, or else you lose money. If you earn $100 because the stock price rises by one point, you still lose $150 because the put cost $250.
In return for excellent insurance against a large loss, it becomes difficult to earn money. This strategy sounds very reasonable, but for most investors, it is just too costly to buy put options as protection. If you believe that a good insurance policy is a necessity, then perhaps you are too bearish on the prospects of the company -- and the best solution may be to sell all (or part) of your stock holding.
If you like the future prospects of a stock well enough to become a stockholder, there are two ways to hedge risk. The more effective is to write covered call options. This does limit profits, but it provides profits when the stock price holds steady. You can choose a strike price that suits your outlook for the stock price. The less efficient method is to buy puts. This costly approach works well when you are confident that a big change in the stock price is coming, but you fear that the move may be to the downside. Owning puts gives you full participation when the stock price soars and limits losses when it dives.