An Argentine default, ongoing geopolitical concerns and well, a market that has seen considerable gains without hesitation over the past five years has finally led to a short-term reprieve. Who knows if the decline will continue . . . but you should be prepared just in case.
Today I’ve decided to give you a glimpse into how I protect profits. Over the past several weeks I have encouraged you to take a look at ways to protect your portfolio.
[ad#Google Adsense 336×280-IA] I’ve discussed the benefits of collars and bear call spreads, but there is an even simpler way to protect profits that is geared towards the newbie options investor.
The strategy: protective puts.
Protective puts are reasonably simple, and more importantly, extremely effective in protecting portfolio gains.
The Protective Put
Let’s say you own 100 shares of Microsoft (Nasdaq: MSFT) and it is currently trading $10 above your original purchase price of $32.
You want to continue holding the position, yet you are concerned that the bull market is about to burst.
Try a LEAPS protective put.
Long-term Equity AnticiPation Securities (LEAPS) are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years.
Example: Microsoft is trading at $42. You purchased 100 shares at $32 over a year ago and wish to hold Microsoft for the long term. You do not want to risk losing the $10 increase in share value, or $1000, and you are perfectly fine paying the cost of insurance if it means that you will be able to keep a decent portion of your current gains.
Outlook: Again, you are bullish on Microsoft over the very long term, but nervous about unseen events over the next three to 18 months.
Strategy: LEAPS Protective Put – Buy 1 MSFT January 2016 40 put for $3.75 per contract or $375 with the stock trading at $42.
The $375 cost of the MSFT LEAPS options insures your stock position to a maximum loss of $575 with unlimited upside potential after the break-even point of MSFT at $45.75, or 8.9% is reached.
The maximum loss is based on the cost of the LEAPS protective put ($500) plus the out-of-the-money amount ($200) at the time of the established position. The most you can lose on MSFT is -13.6%, or $575, no matter how far the stock drops.
The stock could drop back to $40 or below and your max loss would still be ($575).
So, if you are fearful of a sharp push lower in coming months and you want to protect some of your hard-earned long-term profits, think about using a LEAPS protective put. It limits your downside while leaving the upside potential of the stock intact.
— Andy Crowder
Source: Wyatt Investment Research