Welcome back to this important episode of The Winning Investor's Quick and Dirty Tips for Making Money in Any Market!  I'm your host Andrew Horowitz and in this episode, we'll finish up our discussion on how to hedge your portfolio by discussing put options and how they can be used as a defensive tactic when you think the market as a whole, or your particular stock, might suffer a decline over the next few months, but you don't want to sell your stock position or don't feel like the bumpy road ahead will be all that bad.

Keep in mind, this is still an "intermediate" level tip so I would encourage you to learn as much as possible about puts before rushing out and buying them for your portfolio.

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When to Use Hedging Strategies in Your Portfolio

With that in mind, let's go back to our discussion about hedging.  You would use "hedging" strategies in your portfolio ONLY when you felt the market or your stock would be experiencing a bumpy ride or would be falling slightly in value over the next few months, but that the fundamental and chart trend of the stock was still positive.  If you felt that your stock had become fundamentally unsound or you expected a big drop ahead, you would go ahead and sell the stock completely instead of trying to ride out the bad road ahead.

What is a Put Option?

What is a put option?  First, we should note that options are a way to speculate on a stock or market. With options you control a position indirectly with less money. Options have time limits and certain price requirements. We will talk more about these is future episodes. Investors can buy put options, or puts, when they think their stock or the general market is going to go down over the next few months.  Just like shorting a stock, which we discussed in a previous episode, a put option gets more valuable--and makes more money--when the stock price falls.  It really is probably best compared to shorting a stock without really shorting the stock.

When you own a stock and buy a put option it is considered hedging. You can find prices of put options at any popular online financial website like Yahoo or Google Finance.

An Example of Using a Put Option

Let's use the same example of Walmart (WMT) that we discussed in the last episode where I talked about covered calls as a hedging strategy.  Let's say Walmart stock--symbol WMT--trades close to $50 per share.  You own 100 shares of Walmart stock and you want to hold it for a while, but you think that the price might decline over the next few months.  Instead of selling a covered call at $50 per share, you decide you want to buy a put option at $45 per share. As that seems to be the price it could fall to using charts. The $45 is called the strike price. Remember that options expire and you always have to choose a month in which they expire.  They typically expire on the third Friday of every month.

Let's say you decide to purchase or buy a December put option at a strike price of Walmart of $45 per share.  Put options get cheaper as you move down the scale of price.  Remember that one options contract covers 100 shares.  We check Yahoo Finance to see that one put option of Walmart stock at price $45 in December is trading at 50 cents, or what really would be $50 (because we have to multiply the price by 100 shares). 

Remember that put options get more valuable as the price declines.  So if you own shares of Walmart at $50 and you bought a put option and then the price starts to decline, your put option will get more valuable and help offset some, but not all, of the paper losses you are seeing in your Walmart stock.  The Put will get more valuable the more the stock declines. Just like a stock, you can sell your put option either for a profit or a loss at any time until December.  If you want to keep your stock, it's always best to sell your put option sometime before it expires.

Put Options are Like Insurance

Put options are just like insurance premiums.  You buy them like you would insurance for your house or car to protect you if something bad happens.  If the stock stays above the strike price then all you lose-- or all you put at risk--is the money paid to buy the insurance contract or--in this case--the put option.  But if Walmart stock rises, you will lose value in your put option.

If you want to take on more protection, you could buy a December put at $50, but that would cost you more money to insure - a December put at $50 that you purchase in October might cost $2.40, or cost you $240 to purchase that put option for each 100 shares you own.

There's a lot more I could say about put options as hedging strategies, but I only want to open your awareness to them and give you a few quick and dirty tips on how to use them.  I encourage you to read more about options from popular financial websites or books before you rush out and start buying puts left and right.   They can be a welcome addition to a winning investor's portfolio, and many professionals do often use puts and covered calls in their portfolio, but it still is an intermediate level tactic that you can use, but you need to do your research before getting too excited about this new strategy.

Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show.

And if you like the show, tell a friend or leave a review on iTunes. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips wishing you all the best on your quest to investment success.