A 'Dynamic' Downside Approach

We spoke about dynamically hedging our portfolio by purchasing puts in an Exchange-Traded Fund such as the Dow Diamonds (Symbol: DIA), the S&P 500 SPDR (Symbold: SPY), or the Nasdaq-100 Trust (Symbol: QQQQ, also called "the Qs.")

We also said that if our portfolio has just a few stocks in it, we could buy puts in those individual stocks to protect them individually instead of protecting the portfolio as a whole.

Regardless of how you protect your positions (i.e., the whole portfolio at once, or stock-by-stock), you need to know what to do with the protected position in case the expected downside movement does occur.

I have received many e-mails asking about what to do concerning "the next move" … what it is and how it would work.

So Stocks Go Down. Then What?

So many of us, particularly those of you who are newer to the "options scene," don't really understand how these protective puts can function in this scenario.

Many of you lack experience in this type of strategy, so I think it is best to go through the mechanism of this "protective put strategy" to be better prepared for the next big sell-off.

Let's start out with a simple example.

Say we own 500 shares of XYZ Corp. that we bought at $100 per share. To hedge against a possible downside move, we decide to buy five contracts (remember, each contract controls 100 shares of stock) of the January $95-strike put options for $2 per share ($200 per contract) to protect our stock position.

The purchase of the puts would cost us a total of $1,000 (five contracts x 100 shares per contract x $2).

Our ownership of the XYZ Jan 95 Puts gives us the right, but not the obligation, to sell XYZ Corp. at $95 per share at any time between now and January expiration. 

If the stock sells off hard between now and January expiration, we have the right to sell it to someone else at $95, no matter how low the stock goes.

Protective Puts Take You Out of Limbo

So, if we wake up one morning and the stock opens down $60 (at $40), we have the right to sell it at $95 to someone else.

If we did not own the put, we would have a $60 loss even if we had a stop-loss order on our shares for protection.

With the puts in place, our loss is significantly less than it would be without the puts. Instead of the $60 loss if we simply owned the stock without protection, we would only have lost $7.

This maximum loss comes from two things:

• The first is the loss from buying the stock at $100 and then selling the stock out at $95 ($100 - $95 = $5 loss) through the puts.
   
• The second part of the loss is the $2 spent on the puts ...