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Investing Specialists

You Insure Your Car, How About Your Stocks?

Put options allow you to add protection to your equity holdings in the event of a loss.

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After the huge downs and ups in the markets during the past few weeks, I have a feeling that "protection" is a topic very much on people's minds. But there are several ways to protect stock positions using options. One of them is through protective puts.

The Mechanics of a Protective Put
You likely have a great deal of experience in buying protective put options, even if you do not realize you've done so. The puts that we are familiar with buying are those that you buy from companies like
 Allstate (ALL) and
 Travelers (TRV)--insurance on real assets.

Let's break down a familiar transaction: buying car insurance. If you buy full coverage, you write a check and the insurance company promises to indemnify you for the value of your car. Let's say you buy a new car for $20,000 and you insure it for one year, paying $800 in premium with a zero deductible. As soon as you park in your driveway and go inside, a meteor falls on the car and totals it. Clearly, the car is worth $0 now to you. However, your insurance company will write you a check for $20,000--in effect buying a worthless lump of smoking metal for 20 grand.

Put options allow stock investors to buy the same type of insurance protection for their investments as they can for their cars. As with insuring a car, the protection buyer must specify three elements when he buys his insurance: one, the asset to be protected; two, the time over which the protection will last; and three, the deductible (or the amount of loss one is willing to absorb oneself before the insurance kicks in). Let's take a look at how to find the prices of protective put options on Morningstar's option pricing pages using  Enterprise Products Partners (EPD) as an example.

At this writing, the stock was at trading at $42.55 and had a Morningstar Rating for stocks of 3 stars. We have now completed the first step in buying insurance--identifying the asset to be protected. On Morningstar's website, you simply type the ticker into the search box, and when Enterprise Products Partners' summary page comes up, click on the Option tab at the far right of the screen.

We are then taken to a screen that lists the different durations of option contracts available as well as a Control Panel that will allow you to set the data that you want to be displayed. Let's say that we want to protect our Enterprise Products Partners holding through March of next year--this has allowed us to specify the second element of our protection plan: the term of protection. We will Click to Expand on the bar that says "Expiration Mar. 16, 2012 (212 days)."

Now is when we need to make our third and final decision regarding our protection plan--the deductible. The stock is trading for $42.55, and we can choose any strike price listed there; the strike price is simply the price at which the insurer will start compensating us for a loss. If we want premium protection, we might buy the put at the $42 strike price. This means that we would only suffer a loss of $0.55 (the difference between the present stock price and the strike price) ourselves, before our insurance kicks in. Obviously, a policy with a $0.55 deductible is going to be more expensive than the next insurance policy available (the $41-strike put), which has a deductible of $1.55 per share.

Let's say we'd like the premium protection and want to buy the $42-strike put. We find the price of the option by reading over from the $42-strike row to the Ask column, since we are purchasing the option. As of this writing, the $42-strike put option was trading for $3.70 at the ask price.

Morningstar's option price "chains" are great in that they give investors lots of important information. On the Custom Display Controls, you can choose one of those datapoints: Annualized Premium. This figure--14.4% in this case--represents the annualized cost of the option as a percentage of the strike price.

So there we have it--protection on the asset Enterprise Products Partners through March 2012 with a deductible of $0.55 costs $3.70 per share, or about 14.4% annualized.

Important Points About Puts
There are a few things you need to know or think about before embarking on a protective put strategy. The first few things are logistical. Almost all options on single stocks are transacted in a contract size of 100 shares. In other words, even though the price above says $3.70, that is just the per-share price; the check you will actually write to your broker is 100 times that or $370 (plus whatever commissions and fees your broker charges). The next point ties into the issue of contract size, as well. If you own an "odd" number of shares (that is, your holdings are not evenly divisible by 100), you will either have to buy too much or too little protection. Overhedging is not a bad thing, but it means you're paying for protection you don't need.

The last thing, involves the expense of hedging. In the case of Enterprise Products Partners, we're paying $4.25 ($0.55 deductible plus $3.70 in option premium) to protect a $42.55 stock for about seven months. This works out to a maximum annualized percentage charge of 17.7% (if the stock ends up falling and you exercise the option). In auto insurance terms, we would be agreeing to pay a maximum of $3,544 per year to insure a $20,000 car!

A version of this article originally appeared in the April 2011 edition of Morningstar StockInvestor, edited by Paul Larson.

Erik Kobayashi-Solomon is co-editor of the Morningstar OptionInvestor online newsletter and research service, and co-author of the Morningstar Investor Training course on Option Investing. For more about Morningstar's fundamental approach to investing in options, please use the link below to download our free guide to option investing:http://option.morningstar.com/OptionReg/OptionFreeDL1.aspx

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Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.