There are many different ways to protect profits and hedge risk
in a winning stock.
You can use a stop loss order, write calls options, buy put
options, and more.
Today, we're going to talk about buying puts, and compare that to
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
But again, puts can also be used to protect profits and to hedge
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
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
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
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
And be sure to check out our new
Zacks Options Trader
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.
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