3 Defensive Options Strategies to Consider

05/12/2014 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Options are not only for the high-risk strategy of speculators; they can also be used to protect existing portfolio positions, says Michael Thomsett of ThomsettOptions.com, and here he outlines three strategies for reducing risk.

Options are not just speculative devices, but may also serve as effective portfolio management tools. To reduce risk, three strategies need further consideration:

1. Protective puts. The most basic defensive move allowing you to continue holding stock is the long put, also called the “protective” put. This is also termed a synthetic long call; in the event the stock value rises, the overall stock/put long position rises as well. However a problem with the protective put is that is requires payment of the put premium. So if your basis in stock is $50 per share and you buy a 50 put paying a premium of 3 ($300), that means your net basis in stock has to rise to $53 per share. So you need a three-point gain just to break even. For this reason, just buying a protective put leaves a lot to be desired.

2. Synthetic short stock. The second strategy is to create an option-based position that will increase in value point-for-point if and when the stock’s value falls. It consists of one long put and one short call opened at the same strike. The cost of the put is offset by the income from the call. This is a very low-risk position for two reasons. First, the net cost is zero or close to it and, in some instances, even creates a small net credit. Second, if you are trying to protect stock you own, each synthetic position provides protection for 100 shares. The put provides downside protection while the short call is covered.

3. Collars. The collar is very similar to synthetic short stock. It involves 100 shares of stock, a long put and a short call. However, the call and put normally are opened at different strikes so that both are out of the money. If the stock price rises, the call is covered; if the stock price falls, the put grows in value. And because the net cost of the two options is at or close to zero, it does not take very much movement for the long put to become profitable.

The real key to effective use of options is to use them to manage risk, not to replace one risk with another one.

By Michael Thomsett of ThomsettOptions.com

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