Option Investor
Educational Article

Downside Protection

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By Lee Lowell

If you're like me, you've probably got some long stocks in your account that have been taking it on the chin as of late. I'm tired of watching them slowly deteriorate and lose value. It's time to do something and get pro-active!

What's the best plan of action? From a traditional sense, the most likely course to take is either to sell some covered calls or buy some puts. Nothing wrong with that. Many investors (old and new) are in it for the long haul and wish to hold onto their stocks forever and never sell. They are there through thick and thin. They ride it out through the up cycles and down cycles. That's fine. But you know what? You can increase your monthly and yearly returns and never have to worry about giving up your shares as long as you employ some defensive tactics.

What's better - selling calls or buying puts? It depends. Do you want to take in premium by selling calls, and subsequently give up more downside protection? Or do you want to pay a little for a put and have the comfort of knowing you're protected all the way down to zero? Selling calls also caps your upside profits, but you can get around that. Buying puts can be very expensive at times if implied volatility is currently high. So what can we do?

Here's what my situation looks like. I have some telephone stocks that've been in my portfolio for some 16 years or so. They've been steady small gainers over the years with nice dividends. I've been taught to always hold onto stalwarts like these. I've gotten what I expected out these phone stocks - but now I want more. We've seen the returns that tech stocks have rewarded investors over the last 2 years alone. Should I cash in my Old Timers and go for the gusto, or should I continue to hold these slow and steady Eddies? The same thing goes for the Big Blues - IBM's, WMT's, MCD's, etc. These are stocks that you just never sell. But I want to squeeze more out of them and get some protection on these slow downside moves.

I've come to two conclusions: I'm either going to sell these Old Timers and get slapped with a big capital gains payment next April and put the money into tech investments, or I'm going to take a more active role and try to increase my monthly returns. I'll probably do a little of both.

So where do we start? Take a look at all the stocks in your portfolio and see how many contracts you can sell against them or how many put contracts you can buy against them. Each option contract constitutes 100 shares of stock. If you have 500 shares of AT&T, then you can work with 5 option contracts. The next step is to check the stock's volatility and its option premiums. Chances are, some of your stocks will be slow movers so the premiums may not be all that great to sell. But you won't know until you do a little research. Check the stock's past volatility levels. If it's in the higher end of its volatility range, then most likely you'll be able to sell some covered calls. If it's at its low end, then buying puts will probably be a better play. You don't have to concentrate on front-month options only. You might have to go a little further out to get more premium to sell. You can sell the next one or two expiration series if you want to. If you are going to buy puts, then you can either buy an ATM put every expiration cycle or you can buy a further out 3 or 6-month put option. See how the costs compare. You can tailor it any way you want. You can buy slightly OTM or ITM puts. The same thing applies when selling the calls. You can sell ITM, ATM, or OTM call options. The ITM calls will give you more premium into your account and more downside protection, but your upside profit potential will be very limited and your chances for getting called out will be higher.

The opposite is true for OTM calls. You get less downside protection, less premium into your account, but a bigger upside potential for your stock and a lower chance of getting called out. Depends on what you want. Many people sell covered calls just for the income producing effects alone. They don't own any long- standing stocks. They put on the trade simultaneously. They find a quality stock in an uptrend with higher than average volatility, and then pick a call to sell against it. The higher volatility allows the options to have some meat in their premiums. If you buy the puts you'll never have to worry about being called out of your stock which could potentially lead to a huge capital gain payment. Some investors never feel comfortable buying options because they know the odds are usually against them. They would rather sell the calls, take in premium, and play assignment roulette.

If you do want to sell covered calls and continue to keep your stock, then there are a few things you can do to protect yourself against possible assignment. Just know, that if you are getting worried about being assigned, then you are winning on the trade. In order to make money with covered calls, you need the stock to go up. The gain on the stock will always outweigh the loss on the call. So if the call has gone into-the-money, then you are ahead at this point.

Here's what you can do to protect against assignment. Most likely, you will not get an assignment notice unless the option is deep ITM and there are only a few days left before expiration. At this point, you can buy the option back for a loss and sell the next month's covered call. This is called "rolling out". You continue to buy back the close-to-expiring options and sell the next one. This produces a stream of income throughout the whole year. Even though you are buying back the option for a loss, the gain on the stock will be greater. So you can continue to keep your stock, while adding a few hundred or a few thousand dollars to your account each month or every few months. I'm no tax expert, but buying back options for a loss might entitle you to capital loss deductions. (Please consult your tax professional!)

Another way around possible assignment is to sell call spreads against your long stock. You'll take in a smaller credit, but once the price of the stock starts moving up, the spread will cap itself out and you're free to participate in the upward move with no possibility of assignment. If you prefer to play the puts, you can also profit on downmoves as well. Not only will the puts protect you all the way down, but if you feel the stock may have hit bottom; sell the puts out for a profit. If the stock turns around and heads higher, congratulations. You can now either buy another put or let the stock keep trending higher. This type of trading may require a little more participation on your part. If you don't have the time, no problem. Just ride out the put to expiration if you want. That's what you intended to do in the first place.

The whole idea of this article is to get you off the sidelines and use all available resources and tactics. Don't let your stocks sit idle anymore! If you're worried about these downmoves, sell a covered call or buy a put. You'll be glad you did.

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