Daniel is a retired business executive who now devotes most of his free time to trading stocks and stock options in the stock market.
Unfortunately, there is no company (yet) that will take on the risk of offering stock loss insurance to investors. But despite the absence of an organization that offers protection against stock losses, we can still do so by using an innovative method of providing this insurance ourselves.
How? With stock options!
Stock Options as Insurance Protection
Yes, stock options have this special feature of protecting stock investments and it is being widely used by both private and institutional investors on a regular basis.
Protective coverage can be total or partial, depending on how much protection one desires. Just like any other kind of insurance, total coverage is extremely expensive. The more protection one takes, the higher the insurance premium. In fact, with some kinds of insurance, it is not possible to acquire one hundred percent total protection even if one is willing to pay a very high premium. The insurance company just won’t take on the risk.
Similarly, using options as insurance protection against stock loss, it is possible to give oneself ample insurance coverage but probably not 100 percent total protection. Before proceeding further on this subject, let’s talk about who needs coverage against stock losses.
Who Needs Coverage Against Stock Losses?
In most cases where an investor uses options as insurance protection, it is with the intention of protecting PROFITS. It is the profit already earned that one wants to safeguard against loss. Obviously, the best way to safeguard earned profit is to liquidate the stock and pocket the profit.
But in many instances, either because of man’s natural tendency to be greedy or the desire to earn greater profits, the investor wants to hold on to his stock in the hope that the bounty will continue. In this event, it makes sense to take on some kind of protection against a reversal in the market. There are several ways one can do this.
Method No. 1: Buying Puts
This is the easiest, fairly common, most effective but most expensive method of stock loss protection. If you already have some basic knowledge of how options work you should know that buying puts gives you the right to sell your stock at a predetermined price no matter how low the stock price may drop.
Example: If you had bought Advance Micro Devices (AMD) in the early part of 2016, say in April, the price of the stock then was $2.70 and if you had bought 1,000 shares your total investment was $2,700. Today, October 2017, as this article is written, the stock is currently going for $13.23. Your $2,700 investment has now ballooned to $13,230 for a total net profit of $10,530.
You find yourself in a quandary. Do you liquidate your position now and take home the profit already gained or should you stay in the game and hope that AMD continues its upward trend?
You decide to hold on to the stock for another month and see how AMD performs during this period. In the meantime, you protect your profits by buying puts as a hedge against the potential occurrence of a reversal in price.
You look at AMD’s option chain table below and see what put options are available.
The third week of November looks good and you determine that put 14 strike (contract price) works for you. This means that you are guaranteed to sell your AMD shares at $14 no matter how low the stock price drops. This insurance is valid until the third Friday of November at which time you have to decide whether to sell your stock at $14 assuming the stock has dropped below $14. Or, if the stock is higher than $14 you could continue to hold on to your shares and buy new put insurance.
Looking at the option chain below the November 14 put has an ask price of $1.43. As you know you pay the ask price when buying and sell at the bid price when selling stocks or options. You pay a total of $1,430 for your insurance. A stiff price to pay for just about 30 days of insurance coverage. But a small price to pay for sleeping well at night with the assurance of profit protection.
You are guaranteed to be able to sell your AMD stock at $14 per share no matter how low the stock may drop all the way up to the third Friday of November when your insurance (put option) then expires.
Method No. 2: Selling Covered Calls
This is the more economical way of getting insurance for a stock that has risen in value. The drawback here is that you are limited to any potential continued rise in the price of the stock.
As you know buying a call option gives you the right but not the obligation to buy the stock at a predetermined price for a given period of time in the future. So as a seller of a call option, you have the obligation to sell stock at a predetermined price on or before the expiration of the option.
Since as a seller you are compelled to sell your stock at a fixed agreed price (the option strike price) you are therefore limited to sell the stock at that price no matter how high the stock continues to rise in price. This is one of the downsides to this cheap insurance.
The other downside is that the insurance this method offers is rather small if the stock price goes on a swift downward slide. You are only covered by the same amount of the premium you received from the call option sale. More about this in the paragraph following the example below.
The upside is that you don’t pay for this insurance and in fact collect money in the process. And this is why covered call writing or covered call selling is also well known as a means of generating revenues from ownership of stock.
Covered call writing is actually used more for its ability to generate income from stock ownership rather than as protection or insurance coverage against a drop in the stock price.
Example: Using the same scenario of AMD stock you are in deep profit with the stock now trading at the current price of $13.23. Looking at the option chain above you could sell the November 14 call at the bid price of $0.70 and collect $700 for 10 contracts (1 contracts is 100 shares).
You have just generated an income of $700 from your stock but you have also created a ceiling of $14 on the price at which you have to sell the stock. If the price continues to climb higher than 14, say 15, 16, 17 or more, you will not participate in the higher prices since you have committed to sell your AMD shares at the agreed strike price of 14.
There is, of course, a system of circumventing this limitation by using the roll-out process of closing and rolling expiring options.
More than the limitation of higher price benefit the greater downside to writing calls as insurance is its inability to protect against a continued drop in stock price.
If AMD were to lose steam and start dropping in its price you have no protection beyond the price of the call you sold. Meaning you are only protected up to $0.70 of price drop which was the amount you got when you sold the call or $12.53 (13.23 current price less 0.70 sold call). Below $12.53 you are losing your profits for every point drop.
To sum up I would not consider call writing as a good means of insurance against a reversal in the price of a stock. But call writing is an excellent strategy as a means for generating income from your stock.
Method No. 3: Initiating a Stop Loss Order
I believe there is not much I need to say about how one uses this feature to limit potential loss on a stock. This is perhaps the most widely used safeguard against loss from a drop in stock price.
The problem with this feature is that a stock is in constant flex, going up and down all the time. If the ‘stop-loss’ price is too close to the current market price it could be triggered prematurely and the investor would then be out of the game. The stock could then turn around and continue higher thereby losing for the stockholder the opportunity for greater profits.
Method No. 4: Buying Call Options
In this method, one exits his stock position by selling all his shares at a profitable price and using a small portion of his earned profits to buy long-term call options. The goal is to still be in the game should the stock continue its strong performance.
Using AMD again as our example, with its current price now at $13.23 you could just sell off the stock and use part of the $10,530 earned profit to pay for a long-term call option expiring say, six months from today.
In the first insurance method described in No. 1 above, you bought puts to safeguard your stocks spending $1,430 for insurance coverage of just a little over 30 days. By liquidating your stock and using $1,485 of your profits you could buy 9 contracts of the April 2018 calls with strike 14 at an ask price of 1.65 (see the April 2018 option chain below). While you are spending just slightly more than buying puts as in No. 1, your April calls provide insurance coverage of six months instead of only about one month with the put options.
The main difference between this method and that of No. 1 is that with this method you are holding only call options while with No. 1 you still own shares in AMD. Owning the shares will give you more profit potential than the call options.
If the stock price continues to appreciate but at a much slower pace you will still continue to increase your gains penny for penny or dollar for dollar if you owned the stock. This would not be true with the call options that you bought at an OTM price. Due to time decay, your call options will slowly lose value as time passes.
So unless the stock goes on a dramatic and aggressive price rise within the next six months the call options will eventually lose value or appreciate very little. But since call option value appreciation was not your intention in the first place but only as a corollary benefit to the insurance coverage it therefore matters little if it does not appreciate at all.
One other advantage of continuing to own the stock using insurance Method No. 1 is that if it were a stock that pays regular dividends (AMD does not), you would continue to receive dividends as long as you own the stock.
Method No. 5: Initiating a Collar Spread
Here is where it gets somewhat more complicated. By definition, a collar spread is an options trading strategy where one who owns shares of an underlying stock buys protective puts and simultaneously sells call options to offset the cost of the purchased puts. In short, it is a technique of using covered call options to finance the cost of buying the protective puts described in Method No. 1.
If you wanted to buy a longer, more expensive put insurance, say 6 months validity, instead of just one month as mentioned in Method No. 1, you could do so paying only a small minimal premium.
You could buy the 2018 April strike 13 put for 1.75 and sell the April 14 call for 1.61 thus paying only 0.14 for the six months of protective coverage or a total of only $140 for all of your 1,000 shares. But this limits your upside to a maximum price of only 14 at which price you must sell your stock. Of course, you could sell the April 15 or 16 calls thus increasing your upside limit but you would be increasing your premium payments also. If you bought the April 13 put at 1.75 and sold the April 16 call at 0.95 then the premium you pay would be a net $0.80. The stock would have to go up to $16 before your April 16 call is exercised.
So there you have it. Five different strategies for insuring your stock portfolio against losses.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2018 Daniel Mollat