nterest rate cuts are generally good news for stocks. And, in fact, the market did rally last month in response to a surprise cut by the Federal Reserve on Jan. 3 and in anticipation of a second cut that came last week.
Nevertheless, concern about the economic slowdown and a dimming outlook for corporate profits, as reflected in Friday's retreat, could create rocky markets this year. If so, an investment strategy that simply seeks to preserve the value of your portfolio may be a good idea.
One path is to buy put options, which give you the right to sell a stock at a specified price during a certain period.
At first blush, the notion of using options defensively may appear odd. After all, many investors use options to carry out baroque or highly speculative investment strategies. Because they provide leverage, moving up or down in value more than proportionately to changes in the underlying stock, options lend themselves to speculation.
But sometimes, options can reduce risk. For example, buying put options on stocks you own limits your risk by establishing a minimum selling, or floor, price for the shares.
Suppose you own 1,000 shares of AT&T, which closed on Friday at $23.38. By buying April AT&T puts with an exercise, or strike, price (the price at which you have the right to sell the stock) of $25, you can lock in some appreciation. Even if AT&T shares drop sharply, you are guaranteed to be able to sell them for $25 until the option expires on April 20.
The price of the AT&T put option, called the premium, was $2.80. One option contract, which covers 100 shares, would cost $280. (It would cost $2,800 to buy the 10 contracts needed to protect a 1,000-share position, or 11.2 percent of its value, excluding commissions.)
If AT&T closes below the strike price, you can cash in your profit either by "putting" the stock to the seller of the put, or by selling the option, which itself will increase in value. Buying put options would have paid off if AT&T fell below $22.20 ($25 less the $2.80 cost of the option). If AT&T advances instead, you have lost only what you spent for the option, which would expire worthless.
In that case, you would be paying a lot to be able to sell AT&T for $25, because you would have bought an option that is already "in the money," meaning that an immediate exercise would produce a profit.
However, options are cheaper if you do not require complete coverage. For instance, the April put on AT&T with a strike price of $22.50 costs just $1.50. You are still protected against a major price decline, since you can sell the shares for the strike price, but you would have to absorb the decline from $23.38 to $22.50 yourself. This put option is "out of the money," in that it is not yet profitable to exercise.
Why not just place a stop-loss order, which makes your broker sell the stock automatically if it falls to a certain price, or just sell the shares outright if you foresee a decline? After all, either alternative would limit losses without additional cost.
Put options not only curb losses, but they also let investors participate in any appreciation if the shares rebound during the life of the option, said Michael Schwartz, chief option strategist at CIBC Oppenheimer.
Because you are assured of being able to sell the shares at the exercise
price, you can afford to wait for the stock to recover. "Protective puts
are one of the best ways to hedge a stock position while retaining the
opportunity for substantial profit," Mr. Schwartz said.
Instead of hedging individual stocks, you could protect your entire stock portfolio by buying a put option on a stock index, like the Standard & Poor's 500 or the Nasdaq 100, that most closely reflects your portfolio, said Larry McMillan, president of McMillan Analysis in Randolph, N.J. But he cautioned that the match between the stocks in an index and those in your portfolio is probably inexact, and, therefore, so is your protection.
An option on the S.& P. 500 trades on the Chicago Board Options Exchange and covers stock worth 100 times the value of the index. To protect a $1.08 million portfolio, for example, you would need eight contracts.
Protecting a portfolio full of volatile technology stocks could be several percentage points more expensive for comparable coverage. And although most options expire in a few months, Leaps options, for long-term equity anticipation securities options, which mature in one to three years, are also available on indexes and some stocks.
Despite the merits of a defensive option strategy, some strategists say the approach amounts to a bet against yourself. They contend that you should ignore short-term fluctuations if you are confident the stock will appreciate in the long term.
But options do give you the chance to reassess stock or portfolio fundamentals, and they provide comfort if you harbor doubts that you are right.