There are many different ways to protect profits and hedge risk in a winning stock.
You can use a stop loss order, write call options, buy put options, and more.
Today, we're going to talk about buying puts, and compare that to using stops.
Buying puts is probably the closest alternative to using a stop loss. But it does have additional benefits and drawbacks.
First, it's important to remember that when you buy a put option, you stand to profit as the market goes down.
So in general, if someone buys a put, he or she has a bearish outlook.
But again, puts can also be used to protect profits and to hedge risk.
So how does it compare to stop loss orders?
With a stop loss order, you're essentially putting in an order to sell a stock if it goes down to a certain price. If your stock is profitable, and you want to try and lock in a certain portion of your gains in case the market goes down, a stop loss order is a common way to do this.
Let's say you bought $100 shares of a stock at $100 for an investment of $10,000. And it's now at $120. That's a $20 move, or a 20% gain.
You want to stay in, just in case it goes even higher, but you're worried about the downside as it gets ready to report earnings, for example. So you put in a stop loss order at $110.
If it goes down to $110, you're now out and you've locked in a $10 move or a 10% gain, which is $1,000.
The downside is that if it gaps down big, you could lose even more than you intended as that stop loss becomes a market order. In this case, you'll get filled wherever the market allows, even below that $110 level.
Buying a put can offer you protection as well. (And it can give you even better protection in the above gap down scenario.)
Using the same example of buying a stock at $100 that's now at $120, you can instead buy a put for protection.
Let's say you bought a $120 put with a little less than two months of time on it for $600. (Let's say this gave you enough time to go thru earnings.)
If, at expiration, it drops to $110, your put would now be $10 in-the-money, which means it would be worth $1,000. Therefore, you made $400 on the put.
So you're still up $1,000 of your stock buy, but you made an additional $400 on your put for a total of $1,400 on the trade. Essentially, you lost less on the pullback, which means you made more on the trade.
In theory, even if it dropped all the way to $100, which is your purchase price, you're protected in that you'll make the difference between your strike price and the price of the stock.
In that scenario, your stock trade would be back to $0 profit, but you'd be up $1,400 on the put option.
The drawback with the put though is that if the stock stayed at $120 (or in this case, above $114), you would have been better off by just using a stop as the money you spent on the put would be lost or breakeven at best.
So depending on the circumstance, a put might be the better choice for protection. But a stop might be better in other situations.
No strategy is perfect at all times.
But if you're looking for downside protection, especially in a volatile stock, buying a put, in my opinion, is always better than not putting in a stop. And often times, you'll find it more opportune than a stop as well.
The key is in determining where a put makes more sense than a stop and where you'll maximize your efforts in doing so.
Next time, we'll revisit how writing calls can offer you protection as well. But buying puts can offer you full downside protection from your strike price whereas writing calls gives you only limited protection.
You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.