One of the most frequent questions I get as an independent Registered Investment Advisor is “When will the stock market turn down?” Implicit in this question is that it is a certainty. It’s when and not if.
While my crystal ball is a bit foggy on the timing of the stock market turning down, I also believe that it is a case of when and not if. If you also believe the turn is inevitable, I’ve got a strategy for you to consider that can help you protect your stock market profits.
Protect your stock market profits with put options
Many of my clients’ eyes start to glaze over when I start talking about options but this strategy is simple and effective.
Let’s assume you purchased 1,000 shares of Netflix a few years back at $20 per share and its current price is $200 per share. You’ve got a nice gain ($200,000 value now vs. cost of $20,000 or $180,000 gain.) If you do nothing and the price of a share of Netflix falls to $100, you’ve lost $100,000 of your profit with the opportunity to make it back or lose some more.
You can take out some insurance by buying put options on Netflix. The purchase of 1 put option gives the buyer the right (but not the obligation) to sell (or put) 100 shares of Netflix to the seller at a particular price on or before a particular date.
An example of a put option
Since each put option represents 100 shares of Netflix, we will need to purchase 10 put options to cover our 1,000 shares. The price we pay for these put options is going to be dependent on how long we want the option for and the price of Netflix that we can sell it to the put option seller for.
Let’s assume that it is January and we want to be able to sell the 1,000 shares of Netflix any time in the next 6 months (July) for the current price of $200. We might offer to purchase 10 put options for $10,000 (the premium) giving us the option (but not the obligation) to be able to sell our 1,000 shares to the seller for $200 per share anytime between now and July.
If the seller accepts this price, this purchase of put options locks in a minimum amount of $190,000 ($200,000 minus $10,000 premium) that we will receive for our 1,000 Netflix shares between now and July. If Netflix goes to $100 per share by July, we would exercise our option to put our Netflix stock to the seller of the option at $200 per share thereby saving us $90,000 in gains. If Netflix goes to $300 per share, we would not exercise our option and the value of our account would be $290,000 ($300,000 Netflix stock minus the $10,000 premium.)
In the case where Netflix goes to $300 per share, it’s true that we have lost the premium ($10,000) that we paid the seller. But for that premium, we’ve purchased the protection of Netflix going down more that 10 points (5%) between now and July. It has moved more than that on many days!
Is this strategy right for you?
Each investor should determine how much, if any, protection they are willing to pay for. I can help!
Please call me at (610) 999-3599 or click here to learn more about strategies to protect your stock market profits.