Brad Zigler had a problem. Named a fiduciary of a relative's estate this summer, he was charged with preserving the estate's assets until the money could be distributed.
One of those assets was 1,000 shares of Computer Associates, a big software and data processing company that had experienced a huge run-up in its stock price.
Zigler, an executive at the Pacific Exchange, worried that Computer Associates shares would drop before the assets were distributed. But he was barred from selling the stock outright.
His solution: He bought a stock "put" option that effectively placed a limit on how much money the estate could lose if Computer Associates stock indeed slumped.
As it turned out, the stock price did fall--by $23 a share, which meant a drop of $23,000 in value for the estate's shares. But because of the put option Zigler bought, the estate ended up losing less than $4,000.
Individuals who want to remain heavily invested in the stock market--but worry that they may lose a substantial amount of their gains if the market continues to fall--take note: You may be able to use stock options, tools long used by market pros, to reduce the risks in your portfolio.
Here's an explanation of how puts work:
Question: Exactly how did Zigler limit his loss on the stock?
Answer: He bought a publicly traded put option, which gave him the right to sell his shares to another investor at a set price in the future.
Q: How does buying a put work?
A: Buying a put is very much like buying an insurance policy for a particular stock holding. What you're doing is buying the right--but not the obligation--to sell shares that you hold in your portfolio for a set price, called an "exercise" or "strike" price.
This price is likely to be less than the stock's current market value. So you recognize that if you ultimately exercise your put, you will lose the difference between today's market price for the shares and the put exercise price, plus whatever amount you paid for the put.
With the right to unload at a specific price, however, you are setting a limit on how much of a loss you'll sustain on the shares should they dive in price.
If the stock instead soars above the strike price, your put expires worthless.
Q: Can you give an example?
A: Let's take a closer look at Zigler's case, which is fairly classic.
The estate he was managing had 1,000 shares of Computer Associates, which were selling for nearly $57 on June 24, close to the 52-week high price of $61.94.
Zigler wanted to preserve the stock's gains for the estate, while waiting to distribute the assets.
So he bought put options that gave him the right to sell Computer Associates stock for $55 a share at any time before Aug. 21. The put options cost $2 per share, or $2,000, for the 1,000 shares Zigler was protecting.
For the first month that he owned the puts, Computer Associates stock was stable. So the option was declining in value as it got closer to the expiration date of Aug. 21. It was worth only about $1.75 a share on July 21.
But the following day Computer Associates stock plummeted, dropping from $57 to $39.50, after the company warned of weaker earnings because of Asia's woes.
Zigler's option--the right to sell the stock at $55--in turn soared in price, to $15.50 a share.
The company's stock continued to languish until the estate was settled in mid-August. When Zigler finally sold the 1,000 shares of stock, the market price was $33.75 a share, netting the estate just $33,750--instead of the $57,000 it would have brought if Zigler had been able to sell on the day he took over the estate.
But the put option that Zigler bought was worth $21.625 a share at that point. By selling both the stock and the option, the estate ended up with $53,375 after accounting for the $2,000 Zigler initially paid for the option.
The total loss to the estate was just $3,625. Had Zigler not purchased the put option for protection, the estate would have suffered a $23,250 loss.
Q: Couldn't he just have put in a "stop-loss" order, which instructs a broker to sell once a stock drops below a certain threshold?
A: In some instances, stop-loss orders are effective. In this case, it wouldn't have been much help. That's because stop-loss orders instruct a broker to sell "at market" the moment a stock dips below a set price.
But if the stock is plunging--as in Computer Associates' case--it's likely that a stop-loss trade will go through at a much lower price than the stop-loss level itself.
The other disadvantage in using stop-loss orders is that a sale is triggered automatically. Unless you're constantly watching the market and you're quick with the phone, your stock is going to be sold when it drops below the stop-loss threshold--even if that decline is because of general market conditions that may not be long-lasting.
On a day like Aug. 31, for example--when the Dow Jones industrials plunged nearly 513 points--many stocks fell sharply only to recover the next day.
Q: Should I consider buying put options for all my stock holdings?
A: No. This is a form of insurance, and as such it has costs--namely, the price of the put, plus transaction costs. To buy puts for an entire portfolio might be prohibitively expensive. What's more, the insurance a put provides is temporary: Once the exercise date is hit, you must buy another put to keep the insurance in place.
Assuming that you're a long-term investor, you have time to wait through temporary market downturns, so it's best to do without such insurance.
Puts generally only make sense if you are holding a stock for a particular short-term goal and you couldn't meet that goal if the stock price dropped. In this case, if you are reluctant to sell the stock outright prior to the date you need the money--or you have another compelling reason to hold, as did Zigler--the money spent on a put can buy peace of mind.
If you want to learn more about using stock options--not just puts, but also "call" options, which give you the right to buy a stock at a set price by a set date--the Options Industry Council, a coalition of the four exchanges that trade options, is hosting free seminars nationwide.
One of those seminars will be held in Los Angeles on Thursday, from 6 to 9 p.m. at the Renaissance Los Angeles Hotel, 9620 Airport Blvd., Los Angeles, CA 90045.
To reserve a place, call (800) 444-4360. If you want to know about seminars in other areas, log on to the Internet and go to http://www.optionscentral.com for a listing.