In my last post, I congratulated Indian investors and traders for considering the use of stock options as part of their investing strategy.  While this might have seemed at the time a hollow comment, the global market action in the last two days exemplify why options trading should be a vital part of every investor’s toolbox.

US Markets plummet for 2nd day in a row (Chart courtesy Stockcharts.com)

 In the ‘old days’, if the market (or a stock) went down in price, all one did was to hold on to it until it rose again. While this ‘buy and hold’ for the long-term can and has been a strategy of many investors, in today’s markets, it is neither wise nor advisable.

Firstly, Markets can go down and stay down much longer than most folks have patience to wait, and, inevitably, once one loses patience and sells their stocks, they start rising! Or at least it always seems that way.

Secondly, individual stocks can ‘go down’ and ‘stay down’ – nowadays, with so many stocks to choose from, there are always many ‘better opportunities’, and new investors are usually attracted to stocks that are going up. Now, history has shown that really successful investors can learn to recognize good stocks that have been beaten down in value and buy more of them when irrational market conditions drive the price down. Benjamin Graham and Warren Buffet as legendary investors who popularized this type of investing (called ‘value investing’).  However, most people do not have limitless capital to invest in stocks as they go down.  Adding options trading to one’s investing strategies allows one o re-invest in the same stock (if one so chooses) without adding more capital.  In these pages, I propose to show you how to successfully use stock options to do just that.

WHY TRADE STOCK OPTIONS – PUTS AS INSURANCE

The number of ways one can use stock options in one’s investing portfolio is limited only by one’s imagination.  Over the next few weeks, I shall touch upon some of the ones that I have used and found useful.  However, I must first review some basic concepts about stock options.

Here they are …

1. There are two main types of stock options – calls and puts.
2. Buying gives you ‘rights’, selling gives you ‘obligations’
3. If you buy (own) a call, you profit if the market or stock goes up
4. If you buy (own) a put, you profit if the market or stock goes down
5. When you buy something (in this case a call or put), you pay a price (called the ‘premium’)
6. Stock options are ‘wasting assets’ – you only own them for a limited period of time; sort of like an ice cream cone in the summer, it slowly melts away until it is gone.

Since the recent market conditions are ‘bearish’ (going down), let’s consider puts.

1.  If you own a put, you have a right to sell the stock (‘underlying’) at a certain price (called the ‘strike price’).
2. The value of the put depends on the relationship of the price of the stock to ‘strike price’ of the put – whether stock price is above or below the strike price.
3. No matter how low the stock price drops, you will have the right to sell the stock at the ‘strike price’ (until the put expires).

The above succinctly summarizes the benefits and power of adding options trading to one’s investing repertoire.  There is nothing that can replace the peace of mind one gets by knowing that no matter where the markets open the next morning one’s risk is limited by owing ‘put insurance’.

Stock investors often believe setting ‘stop losses’ can protect them – however, that is only partly true, as it only works if the stock slowly slides down. It does not protect one if the stock ‘gaps’ down or opens down the following morning.  Also, owing put options allows one not only to protect oneself to the downside, but also to make money to the down side.   More on this later …  next time …

Happy Trading!

If you who currently trade stock options in India –

Do you buy put to protect your portfolio? If so, please share an example when owning puts helped save you from a major loss. 

 If you don’t currently trade stock options in India –

Have you had a stock that you were sure would go up, and you held on for the long-term as it kept sliding lower? Would you like to know how you might not only have protected yourself, but also make money as the stock kept sliding?(Of course, this strategy can only work for stocks that have options)