Insure Your Investment
You insure your home. You insure your life and the lives of your loved ones. Why not insure your investments?
With current market conditions tossing most portfolios around, it would make sense to protect your portfolio. After all, the work we do significantly lowers the risk of losing money in an investment we choose to get involved in. But we never completely eliminate all the risk in the market.
Buying a protective put will help protect your new stock purchases in the market. This can be really helpful when you want to buy a particular stock, but the overall bias in the market is down. What is a put? A put is a contract that gives the buyer the right to sell stock at a certain price and during a defined period of time, up to the expiration of the contract.
When you buy a stock, three possible events can occur.
? The stock can go up.
? The stock can do nothing
? The stock can go down.
In two of the three scenarios above, you do NOT make money. In one of the scenarios (where the stock goes down), you have a significant chance to lose money. Let?s focus on what happens when you lose money.
At this point, I think it?s prudent to draw a comparison. If you drive a car, and your car is wrecked in an accident, you have insurance to put you back ?whole? or close to it, again. A put works in similar fashion.
Suppose when you buy a stock at $80, you also buy a put that expires in 6 months, and you pay $3 for that contract. Much like insuring your car for the next 6 months. If nothing happens to your car over the next 6 months, you won?t get that insurance premium returned to you, will you? You won?t get it returned?and in fact, you will usually pay another premium to cover your car for another 6 months.
The purchase of the put means you can sell the stock at $80 anytime before the contract expires. Even if the stock drops to $35, you have the right to sell at $80.
If the stock goes along as planned, and goes up, congratulations, you?ve made money. The premium you paid for the put was for insurance for the six months. Just like the example with your auto insurance, that money will not be returned to you (it was the cost of coverage).
If the stock does nothing, although you have not made any money, you know that your investment was covered in case of something negative happening for the last six months.
If the stock goes down, you have coverage, and you also have choices. Remember what you own with a put is the right to sell the stock, in this example, at $80, no matter what?s the current price of the stock (whether it is $75, $45, or even $1).
? You can sell the put in the open market for whatever is the current value.
? You can exercise the option and ?put? the stock to someone at $80, no matter what the current price of the stock.
If you decide to exercise the put, you have yet another set of choices. You can put the money in your pocket (remember that you effectively sold the stock for $80). Or you can buy the stock back at the lower market price, if you like the stock and think it makes sense for you. If the stock has dropped a lot, you could conceivably buy even more shares than you originally purchased.
This strategy isn?t for everyone. And you shouldn?t rely on this article as complete and personalized investment advice for your situation. But if you are investing money that you care about, whether it is in a home, a car or a stock, you should take steps to protect it. Which is why we should really talk.
With the market on defense, it makes sense to have some protection for some of your prized possessions.
I hear too many people say they?re staying away from the stock market, because it is too risky and you can lose a great deal of money. Without measuring or knowing the risk, or a game plan in place, you are almost certain to lose money. In my next article, I?ll share with you a strategy that can limit the amount of money you lose in a stock, to a small amount. This approach can keep you afloat in the market longer than trying your luck on buying a single stock.
About the Author: Thomas P. Mullooly, President of Mullooly Asset Management, LLC (http://www.mullooly.net) has spent over twenty years in the investment industry, as a broker and as an investment advisor.