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January 28, 2020
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Protecting Your Investments
by Chris Verhaegh

MFN Many a company that was once a high flyer, no longer exists. Enron being a great example, but what about the Bethlehem Steel and other companies that previously employed tens of thousands? Would you like to have had all of your retirement funds in company stock to watch the company disappear?

I don’t know whether you have a 401K or another type of pension fund, but you may be able to insure against its demise. These strategies work with many stocks, not just ones in retirement accounts, so everyone should pay attention.

Owning stock has one major risk; dropping prices. Two easy ways to avoid this risk exist; stop loss orders and Protective Puts. Every active trader knows stop loss orders cost less than Protective Puts, at least initially. You get what you pay for. Be aware, free insurance really doesn’t insure.

Stop loss orders work well in certain situations. Nonvolatile markets top this list. But when things are being whipsawed, stop loss orders have drawbacks. They don’t work well with gaps. Furthermore, they’ve been known to be targets for professional traders to try to steal stock. More importantly, most if not all pension funds don’t allow stop orders.

Puts, whether you use them or not, cost money. But the best Protective Puts are the ones you don’t need. Think of Protective Puts as an insurance policy. When working best, insurance should be inexpensive and a waste of money. I don’t want to collect on my life insurance. It’s just nice to know I have insurance.

If you own a stock for the long haul, you should consider buying a Protective Put. When insuring stocks with Protective Puts, you should always buy a Put with a lower strike price than the stock. You want to the Put to expire. You’re buying peace of mind. You need to be willing to insure the first little drop. You want the Puts to avoid catastrophic loss.

Buying Out-of-the-Money (OTM) Puts cost less than buying At-the-Money (ATM) or In-the-Money (ITM) Puts. As with any insurance policy, the best Puts are the ones you don’t use. Again, you buy them for piece of mind. Sine OTM Puts are less expensive, you can buy them with longer term expirations. These long-term options can insure against a stock’s decline for multiple months, at a low cost per month. The best insurance is the least expensive, only if you don’t use it. If you ever make a claim, the best insurance is any insurance you own.

By buying longer-term Protective Puts, you have long term insurance. As these Puts start to decay in time value, they could be sold and even longer-term Puts can be bought to replace them. Options suffer faster decay immediately before expiration. Avoiding this rapid decay lowers the month to month cost of insurance further. In addition, the new Pus could be bought with higher strike prices. Doing so locks in more of the stock’s appreciation. There is also a way to profit from Puts you hope expire worthless.

Instead of selling these now short term Puts, they can be used for directional plays. If you hold a stock for long term appreciation and hold long term Protective Puts, any short-term dip can now be a profitable situation. Riding out the dips with your insured stock, appeals so much more as you profit from short term Puts increasing in value.

Normally thought of as either insurance or a bearish market bet, Puts can be used as a component in bullish plays. Instead of selling the short term Puts, they could become the long leg of a Bull Put Spread.

Bull Put Spreads involve buying a Put with a lower strike price and selling a Put with a higher strike price. The higher the strike price Puts will pay more than the lower strike price ones. Successfully done, Bull Put Spreads will have all the options expire worthless. You will lose on your options, but the person who bought the higher strike price Put will lose more.

Telling you to insure against a catastrophic loss, only works if you haven’t already suffered a loss. Hopefully most of you haven’t, nor ever will. With the proper insurance, your biggest loss should be a Protective Put that expires worthless.
How to Make Money Investing

 
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