Insure Your Portfolio Against Huge Losses

The stories are already beginning to trickle in. In the months to follow, the stream will no doubt become a flood: A couple whose retirement is in doubt because they had much of their portfolio in presumably solid, safe giants like Wachovia (NYSE: WB) or Fannie Mae (NYSE: FNM). Parents who no longer have the college money they were saving for their 16-year-old, because they kept all of it in the market too long, instead of taking it out at least three years before they would need it. Retired sixtysomethings who may need to come out of retirement because they can't draw down their already depleted portfolios.

And that's not even including damage to shareholders of supposedly recession-proof stalwarts General Electric (NYSE: GE), AT&T (NYSE: T), and Pfizer (NYSE: PFE), among many others.

It's twice as terrible to hear these stories, because they could have been prevented -- and much of the worry, stress, and loss sidestepped.

What lesson can we draw from the past year to help shield our portfolios from losses in the future? While almost nobody could have predicted the collapse of so many American institutions, from Lehman to AIG (NYSE: AIG), there is at least one step we can take to protect ourselves against future unknowns when the stakes are high: Use options for insurance.

Options are tools, not weapons
Around Fooldom, options have typically been given the polite brush aside. "Most investors," the argument goes, "do not need to use options to succeed over a lifetime." Which is true. "And most investors will lose money on options." Which is not true, and not entirely the point, if you use options in the right ways.

For those unfamiliar, options are simply the right to buy or sell a stock at a set price by a specific date. Options were introduced to the public in 1973 by the Chicago Board Options Exchange. They've enjoyed increasing trading volume annually for years as people learn about their value.

I was skeptical of options for several years, too, until I started to learn more about them from Motley Fool articles written around 2000. The past eight years, and especially the past five, I've happily used options in managing real-money public portfolios, as well as in my own portfolio. They've helped me to obtain better buy and sell prices, to bet against some positions or hedge others, and to insure against possible declines.

Buying put options for insurance, especially when you have a lot riding on a few positions, can be as smart as having insurance to protect your house against fire.

How puts work
A put option gives its holder the right to sell a stock at a set price by a certain date. Buying a put option when you also own the stock is basically buying insurance for your stock, or hedging against a possible decline.

For instance, if you own 1,000 shares of Citigroup (NYSE: C), currently trading around $23, you could buy 10 put option contracts (each contract represents 100 shares of stock) to insure your entire position against further decline.

Today, it would cost you about $3.75 per share to insure a $20 sell price (strike price) on your Citigroup shares all the way until mid-January 2010.

So, even if Citigroup fell to $0 during the next 15 months, the put option owner would be able to sell out at $20 – for a net sell price of $16.25 after accounting for the cost of the puts.

If Citigroup falls less far, and you still believe in its long-term potential, you can sell the puts for a profit and continue to own the shares.

On the other hand, if Citigroup is $35 per share a year from now, your $20 insurance policy won't have much value anymore. Still, you were protected on the downside for the past year, and you've profited with the stock as it increased.

There are also secondary benefits. The knowledge that your largest holding is insured may make you comfortable enough to nibble on newly beaten-down opportunities you see, or to keep holding the other, smaller positions you already own.

At the very least, with your key positions insured, you won't run for the hills and sell out at the very worst times. And when the markets recover, you'll participate.

When to use puts
It's not cheap to insure large positions for long periods of time, especially in today's environment. But in these times, that up-front cost can be dwarfed by the losses you might then avoid.

Generally, you should consider put options as insurance for positions that are large or vital in your portfolio, or that face more risk now than you originally presumed. Also, if you're preparing to sell a position in the next year or two, puts are a handy way to insure yourself a minimum sell price by your chosen sell date. You pay for the privilege, but from there it's all upside, with no worries about downside.

Use options to take advantage of your knowledge of a stock
I use options to leverage my existing knowledge of a stock's valuation and business model. Many lucrative option strategies exist for stock-based investors -- strategies that complement your stock portfolio, rather than compromise it. I'm not an options speculator or trader. I'm a stock-based investor who understands the power of options when used in conjunction with stock knowledge -- and when used for risk management.