Using put options to limit losses on CME and GOOG; GMI back to +5

Well, I noted yesterday that we may have made a short term top. The GMI went back to +5 when the number of successful 10 day new highs fell below 100, to 76. There were only 136 new highs, the lowest in eight days, and 37 new lows.   Only 46% of the Nasdaq 100 stocks rose, 39% of the S&P 500 stocks, and 33% of the Dow 30 stocks.

I told you yesterday that I had raised my stops, and I got stopped out of BOOM today.   I did not want to get stopped out of GOOG and CME, and I knew that if we had a sudden decline I might get shaken out only to see the stock rebound by the end of the month. So, I bought insurance instead.

Do you call your agent and complain about the home insurance premium you paid last year, because your house did not burn down? Worse still, do you complain that you didn’t need to use your life insurance this year?   No, the insurance is there to protect you from the worst case scenario, and you do not regret buying the insurance if you did not have to use it.   Well, what if you could buy insurance against a decline in your stock.   Would you mind paying the insurance premium even if your stock did not decline?   If not, then pay attention while I tell you how you can buy insurance to protect yourself from a decline in a stock you want to hold on to.

This technique is a very conservative method for using put options to insure yourself against a loss.   A put option gives you the right to sell 100 shares of a stock at a set price (the strike price) for a set period of time. You buy and sell put options through your broker just like you trade stocks.   The only thing you need to do is complete an application for trading options in your account. My broker (Brown) even allows me to trade options in my IRA account.

So, here I am with some shares of CME, which closed today at 243.49.   I think the stock will eventually go up after this short bout of market weakness.   I could simply place a stop order in to sell the stock at a place I am comfortable with, say $230 per share.   Now, if CME trades as low as $230, I will be sold out at the market (next best price available).   Then, if CME goes back above $230 in the following days, I will kick myself for having been shaken out of the stock.

Instead of placing the stop, I go to www.finance.yahoo.com and enter the symbol CME.   I then click on options in the left column.   Up comes the June options page for CME.   But I am not interested in June options, which expire on the 3rd Friday of the month, June 17. This is because I want my option to go through the end of June.   So, I could click on the July tab to get all options that expire in July.   But since I know I am interested in a put option with a strike price of 230, I just click on the number 230 and I get a display of all options with a strike price of 230 that expire over the next few months.

Scroll down to the put options.   The July 230 put option closed at $5.30 per share with a bid of $5.10 and an offer of $5.60.   That means I can buy a July 230 put on 100 shares of CME for somewhere between $510 and $560.   Usually, when I buy an option I put in a limit order in the middle of the bid/offer prices, here about $5.35 per share.   Now, this option gives me the right to tell my broker to sell my 100 shares of CME at $230/share to the person who sold me the option, anytime through the 3rd Friday in July.   (Don’t worry, you just tell the broker to execute the option and your stock is automatically sold at $230 per share.)

Now here is the good part.   From the time I bought my put (insurance) I do not have to worry about whether CME falls to zero.   I always have the right to get $230 per share.   IF CME falls to $200 and then climbs to $260 before the July expiration, I just sell my   shares at $260 and let the put option expire worthless (No one wants to execute the option to sell the stock at $230 when they can sell it in the open market for more.)   So I sell my stock at $260, but I have given up the option premium of $5.35 per share.   So my profit is reduced by the cost of the put insurance.   (Profit= sale price – purchase price-cost of option.) Now, am I going to complain that I did not need to execute the option (insurance) to sell the stock at $230 per share–I think not.

There are many variations on this theme.   I can buy more puts than I own shares and profit more if the stock declines.   I can also sell my put back if I think the stock has bottomed out and then make more profit on a subsequent rise in the stock.

So today I canceled my stop losses on GOOG and CME and bought puts as insurance.   I can now sleep easy knowing that if the stocks decline I have limited my potential losses.   And if the rally resumes, I can participate in it without having been shaken out prematurely.   Why don’t financial advisors tell more people about this important way to protect their stock investments?   Everyone is brainwashed into thinking that all uses of options are too risky for the public.   Not true.   Perhaps you should check out your options.   To read up on this and other uses of options go to the CBOE learning center.

So now I can sleep easy as the market toys with CME and GOOG.