Protecting Your Profits: A Stock Options Primer

By WALTER HAMILTON

Jan. 19, 1999 12 AM PT

TIMES STAFF WRITER

The last three months have been every investor’s dream. The stock market has gone vertical and people have made gobs of money.

But after last week’s wild market swings tied to Brazil’s currency devaluation, what if stocks are poised to tumble again--and perhaps even more sharply than they did in August and September?

To protect their portfolio gains, investors can, of course, sell all or part of any stock they fear may decline. But if the shares keep rising, they would miss out on those additional gains. Plus, any sale of stock triggers capital gains taxes.

An alternative is to use stock options--publicly traded “puts” or “calls”--to lock in profits.

Think of options as you would any type of insurance policy. Options can be pricey--and often expire unused--but you appreciate the protection when it’s needed.

Options are contracts that give the buyer the right, but not the obligation, to buy or sell stocks at specified prices by a specified date.

Buying a put option gives an investor the right to sell a stock at a certain price, known as the strike price, on or before a set expiration date.

A call option, by contrast, confers the right to buy a stock at a certain price by a set date.

Each put or call option contract covers 100 shares. The strike prices and expirations of available contracts vary for each of the hundreds of stocks covered by options. The contracts, which trade on major options exchanges such as the Pacific Exchange and the Chicago Board Options Exchange, can easily be traded via most full-service, discount or Internet brokerages.

Do You Really Need the Protection?

Before buying the insurance protection an option provides, an investor first must ask whether he or she really needs protection.

In the case of individual stocks there’s no easy answer, but one useful tool is to gauge the stock’s relative strength against the broad market, said Todd Salamone, trading manager at Schaeffer’s Investment Research in Cincinnati.

If a stock’s relative strength is falling, that means the stock is weakening in comparison to the market, as measured by, say, the Standard & Poor’s 500-stock index. That could be a signal that the share price is vulnerable to a steeper decline in the near term.

On the Internet, relative strength can be easily measured at many technical analysis Web sites, such as BigCharts (https://www.bigcharts.com). Or it can be figured by simply calculating the percentage return of both the stock and the index since a specific date.

To see how this works, imagine you bought 100 shares of IBM at $120 each in early October. The stock peaked at $192.75 earlier this month and closed Friday at $184.94.

IBM’s relative strength has weakened in the last three weeks. Fearing the stock may have topped out after its powerful advance since October, you decide to buy some short-term insurance.

The most basic strategy is to buy a put option.

Say you buy an April 170 IBM put. That means that if the stock drops below $170 any time before the third Friday in April, you can exercise the option to sell 100 shares of IBM at $170 a share. (Options expiring in a particular month always do so on the third Friday.)

As of last Friday, the cost, or premium, of that IBM option was $7.25 a share, excluding brokerage commissions. Because each contract covers 100 shares, the contract price is $725.

So factoring in that cost, the investor, in effect, is covered for any drop in IBM below $162.75 a share.

If IBM stock remains above $170 between now and the April expiration date, the put expires and you’re out $725.

However, if the stock declines sharply in that period, you’ve inoculated yourself against a steep loss, because your option contract will rise in value as the stock sinks. “If you buy puts on a portion of your portfolio, you’re cushioning any blow from a big downside move,” Salamone said.

Depending on the stock and the specifics of the option, it’s not always necessary to protect an entire portfolio, some experts say. Someone holding 500 IBM shares, for example, might buy three contracts (covering 300 shares) and track the stock’s performance before making another move.

“I always like to edge into any strategy,” said David Caplan, publisher of the newsletter Opportunities in Options in Agoura Hills.

Net Stocks May Not Be Worth Insuring

Buying puts can provide temporary insurance at a reasonable price for most stocks, experts say. But for anyone playing Internet stocks these days, options can be prohibitively expensive.

For example, consider Yahoo.

Even as the broad market roared back to life Friday after a mid-week sell-off, shares of the Internet search engine company continued to sink, to $317 from a peak of $445 four days earlier.

Yet the April 300 put option on Yahoo costs $56.38 a share, or almost 19% of the value of the option at its expiration. That’s a hefty $5,638 for each 100-share contract.

Prices of Internet options can gyrate wildly in response to the volatility of their underlying stocks. On Jan. 11, when Yahoo closed at $414.50, an April 360 put cost $54.50 a share. But by Friday, the price had soared to $92 a share.

“With an Internet stock, you’re really between a rock and a hard place because they’re really expensive” options, said Lawrence McMillan, president of McMillan Analysis Corp., an options consultant and publisher in Randolph, N.J.

So it simply may not be worth the cost to try to insure Internet stock gains with options.

Besides buying put options, investors can use a second hedging strategy for their stocks: Selling, or writing, what’s known as a covered call option. This gives another investor the right to buy shares from you at a certain price by a set date. (By contrast, a “naked” call allows you to sell a call on a stock you don’t own.)

The benefit of writing a covered call is that unlike paying a premium to buy a put, you collect a premium by selling the call to another investor.

Some experts advise selling an “out-of-the-money” call. That means the strike, or expiration, price of the option (the price at which it begins to be worth something) is higher than the current stock price.

In the IBM example, you could sell the April 210 call now priced at $5.13 a share. That means you would receive $513 for a 100-share contract.

The premium derived from selling the call would partially offset any drop in the price of the stock between now and the option’s expiration. In the best-case scenario, IBM’s market price would rise slightly but remain below $210. You’d hold on to your stock and pocket the option premium.

Covered Calls Have Major Drawbacks

But while writing covered calls may appear attractive, the strategy has two big drawbacks.

First, you’re far from being fully insured if the stock tumbles hard. The $513 premium would be of minimal consolation if IBM skidded to, say, $150--a price drop of $3,494, from current levels, on a 100-share block.

“It’s only a hedge to the extent of the premium you receive,” said Michael Schwartz, chief options strategist at CIBC Oppenheimer, a New York-based investment firm.

Second, if IBM’s market price jumps to, say, $240, your shares would be called away from you by the call owner at $210 a share--so you’d forfeit that additional $30-a-share gain.

“Unfortunately, when people sell calls against stock that they think has topped out, it repeatedly works to the negative when the stock keeps going up,” Schwartz said.

A third options strategy, known as a collar, combines the use of puts and calls. It involves simultaneously buying a put and selling a call. You cap your upside in the stock you’re protecting but limit any damage from a steep price slide.

What’s more, the premium received from selling the call can partially or fully offset the cost of buying the put. “You’re really not paying for protection like you would if you just purchased the put,” Caplan said.

What if you’d like to protect your entire portfolio, as opposed to individual stocks? You can use put and call options on major stock indexes such as the S&P; 500.

For example, say you have a portfolio of blue-chip stocks worth about $125,000. You could buy a put on the S&P; 500 to hedge against a sharp drop in the index’s value, on the assumption that if the index falls, so will your portfolio.

The S&P; 500 closed Friday just above 1,243. Multiply that figure by 100 and the resulting $124,300 is the value of a single index put option contract.

Say you buy the March 1,250 put, which insures against a decline below that level. The current market price is $5,838, or roughly 4.7% of the value of a $125,000 portfolio.

If the index finishes at, say, 1,100 on the contract’s expiration date of the third Friday of March--a drop of 150 points--the option would be worth 150 times $100, or $15,000. Subtract your cost ($5,838) and you wind up with a net gain of about $9,162 to offset any decline in your portfolio.

If the market rises, of course, the contract is worthless and expires after costing you $5,838. But all insurance costs money. The only question is how badly you think you need it.

Walter Hamilton can be reached by e-mail at walter.hamilton

@latimes.com.

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Some Put and Call Strategies

INDIVIDUAL STOCKS

Say you bought 100 shares of IBM at $120 in October. You can choose from among several option strategies to protect, by varying degrees, against a sharp drop in the share price:

* Buy a put: Purchase the April 170 put, which currently costs $725 plus commissions of about $40. In effect, this protects against a drop in IBM’s share price below $162.75 by late April.

* Sell a covered call: Sell an April 210 call, currently worth $513, minus $40 commission charges. That premium income would partially offset any drop in the stock price.

* Create a collar: Buy the put above and, to partially offset its cost, sell the covered call at the same time.

DIVERSIFIED PORTFOLIOS

An investor with a portfolio of $125,000 in blue-chip stocks can hedge against a broad market pullback with an index option:

* Buy an S&P; 500 put: With the Standard & Poor’s 500 index at roughly 1,243 today, purchase the March 1,250 put option on the index (current price: $5,838). Say the S&P; were to drop 11.5%, to 1,100, by the option’s expiration. The contract’s payoff would be $15,000, which is calculated by multiplying the difference in S&P; points (150) by $100. After the option’s cost, you would thus offset $9,162 of any decline in your portfolio.

Source: Times research (BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Resources for Options Traders

Here are some resources for investors interested in options:

OPTION EXCHANGE INTERNET SITES

Site / Web address

Chicago Board Options Exchange / https://www.cboe.com

Pacific Exchange / https://www.pacificex.com

Philadelphia Stock Exchange / https://www.phlx.com

American Stock Exchange / https://www.amex.com

BOOKS

* “Getting Started in Options,” by Michael Thomsett (John Wiley & Sons, $18.95)

* “The Conservative Investor’s Guide to Trading Options,” by LeRoy Gross (John Wiley & Sons, $34.95)