Use Options to Manage Your Stock Portfolio Risk

You can diversify some of your risk away by maintaining a well diversified portfolio. But what can you do to guard against losses during total market declines such as occurred during 2008? You can buy put options to hedge against declines in the value of your portfolio.

Large scale investors insure against losses using the same types of methods, just more customized. You can't walk into Goldman Sachs and have them put together a special product for you to buy, but you can buy puts on the S&P 500 as well as individual stocks.

Most any stock you have heard of, along with many exchange traded funds have options available for trade. ETFs and stocks with very small volume will most likely not have any significant options for sale.

Options pricing is based on many factors including demand, time to expiration and strike price. The strike price, also known as the exercise price, is the minimum amount you have contracted to receive when you purchase a put option. In a call option it is the maximum price you will pay. With put options the largest factor determining the price is the strike price. The higher the minimum price you chose the more you will pay.

Using put options without breaking the bank

Hedging against risk is expensive, especially in the long term. One way to reduce the out of pocket cost is to trade some of your upside potential to reduce your downside risk. By selling calls you will lose some of the increase, but receive a premium today. The premium can be used to purchase puts to limit your risk of loss.

The only thing to be especially concerned with in using options is the cost of commissions, if you start using options extensively your broker will love you.