If you're tired of speculating in the markets, perhaps you're considering turning your over money to someone else to handle or just buying one or more of the securities that purport to create a balanced portfolio. You don't need options any longer, right?

Wrong. Options were originally invented to control risk, and perhaps that's still their best use. Imagine that a mythical trader had just inherited bunches of money and was easing into investments in various asset classes. Near the close on February 25, this trader decided that GOOG was about to break to the upside through the top of a flag-shaped pullback on a weekly chart. Note: remember that I rough out my articles a week or two ahead of publication, so charts are not current.

Weekly Chart of GOOG, as of February 25:

The trader decided to buy 100 shares. However, GOOG had been on a long march higher since its 2007 low below $150/share, and our hypothetical trader didn't really want to risk following it down all the way to even a 50 percent retracement of that climb, down in the $370-ish range.

GOOG's Climb off 2007 Low:

Buying that 100 shares was going to set the trader back $55,548 plus commissions, but the trader's Grandma Ione would come back from the grave and haunt that trader if the trader lost more than $10,000 of her money on an investment in a tech company. Consider the following possibility that employs options as they were originally employed.

Analyze Page from Think-or-Swim, Stock plus Put Position:

The long put that was added to the position was a GOOG 100 SEP 15 480 Put. As you can see from the flattened horizontal run of the (red) expiration line on the left-hand side of the chart, the maximum loss is capped above $10,000. Even including commissions, that loss would be less than $10,000.

Problem solved? There is, of course, a but to be considered. But the trader is going to pay for that protection, and when September's expiration period passes, the trader is going to have to pay again. Puts used this way are insurance, the kind of insurance that options were invented to provide. How much was the trader going to pay?

Market Depth for the GOOG 100 SEP 15 480 Put as of February 25, Including Mark or Mid-Price, According to Think-or-Swim:

Yikes. Perhaps our trader hesitates to pay $10.05/contract x 100 multiplier x 1 contract = $1,005 plus commissions for that put protection for those months. That's more than you'd pay for homeowner's insurance for that period of time in many parts of the country.

But there's Grandma Ione, already haunting our trader's nightmares. Plus, there's the worry about the length of time it's been since the last major market pullback nagging the trader.

How is this hypothetical trader going to resolve this dilemma? The trader could sell a call contract against the long stock each option expiration period until September's expiration, eventually recouping some, most or even all of the cost of the put insurance. Of course, selling a call contract against the long GOOG stock risks the stock being called away if GOOG moves above the strike price as the call's expiration approaches and time value evaporates. That's not what our trader wants. Therefore, some months, the trader might have to buy back the call at a loss or roll it forward and/or higher. The process does allow for a participation in gains in GOOG, but at a dampened rate.

I've used the example of GOOG stock to describe a collar, a position in which a long put position is entered to provide protection against a loss in a long stock, LEAP call or similar position and a shorter-term call is sold to recoup part of the put's cost. An entire equity portfolio can be collared using SPX, SPY, RUT, IWM or other index-related options. Our hypothetical trader would need to be able to "beta weight" a portfolio against the SPX or the other underlying to determine how many contracts of options would be needed. It's not always a straightforward endeavor if your brokerage platform doesn't provide for beta weighting. Traders would need to consult their brokerages' customer services for help with beta weighting.

Sounds like a pain, doesn't it? Of course it does. It's always a pain to buy and pay for insurance, whether that's car, home or investment insurance. There are tax consequences, too, including those pesky wash sale calculations. However, many studies have shown that this technique--creating a collar--can be an effective way to manage risk.

The CBOE has created a handy index, the CLL, to show the performance of a collaring strategy. According to this product page, the strategy behind the CLL includes holding the stocks in the SPX, buying three month put options (rather than the further-out one I used in my GOOG example), and selling one-month call options to help offset the cost of the put protection. I'm not suggesting that our subscribers buy all 500 stocks in the SPX and then collar them, not unless they have extremely deep pockets and understand the process! The following chart, however, shows that such a process does often allow for a participation in gains while tempering losses.

SPX 95/110 Collar, One-Year Chart:

As the chart illustrates, the collared position did participate in gains. If the SPX had turned down sharply, the CLL would have stalled or turned down, too, but losses would have been tempered.

I'm not an expert on collars, but I have used some forms of them in my own long-term investments. This article is not a how-to on how to collar your assets or even an admonition that everyone should be collaring their equity investments. It's meant to a be an introduction to or reminder of the strategy, to be investigated further if the subscriber is interested. The CBOE's product page from above includes links to several studies and white pages. I would urge some study of those for all investors who have long-term holdings. Then you may or may not employ some of the techniques included.

Traders can employ other methods for protecting investments, of course. Ask most--but not all--money managers about managing risk, and you'll hear talk about diversification among different asset types.

The trouble is that, sometimes, the behavior of different asset types is most strongly correlated during downturns, the time when you want different asset types to behave differently (Schmitt, Dr. Christian. "Rethinking the herd"). In his article, Dr. Schmitt concluded that "the diversification benefit still persists--even though at a lower level," with the "lower level" due to those greater correlations in the behavior of different asset types during downturns. You don't need a doctorate to know this, however. Instead, ask those who diversified into emerging markets as a way of managing risk before our last two major downturns. I know some traders who didn't fare as well as they expected.

Of course, some of you will be commenting that all one needed to do was follow the old buy-and-hold strategy and all would be well. All is well. The markets rebounded.

Except, some people lost jobs during the last downturn. Some 50+ people lost jobs, to name one group. Some people with handicaps whose insurance costs hurt their companies lost their jobs. I know some people who had that experience, too. Some such people were forced to withdraw their savings during or immediately after the downturn, without an opportunity to fully participate in the rebound. This isn't some kind of political statement. I'm talking investing and the reality that not everyone can wait out a rebound off a downturn.

So, whatcha going to do? There is also diversification into rental homes or gold or art. Dr. Schmitt mentions some barriers to alternative new asset classes such as timber, farmland, etc. He cautions "prudent monitoring of the market environment and emerging asset classes, and the use of dynamic asset allocation." Hmm. To be honest, I'm not sure I could dynamically reallocate assets in a favorable manner all the time.

I would add a further suggestion that's seldom considered and offers fewer barriers: consider utilizing protective puts and/or collars.

Linda Piazza