One of the simplest ways to insure that you never have a big loss on a stock again is to also buy puts on that stock or ETF.
Put options can be used for just that, insurance against catastrophic losses. If you look at it that way, this strategy will work nicely for you.
Lets make an analogy with health insurance. If you pay for health insurance, you hope you never have to use it right? When I sold health insurance I did come across folks who wanted to be covered for every little thing that could possibly happen. If their nose ran they wanted to be able to go to the doctor, and not have to pay anything out of pocket. Those type of folks normally did not have much money, or were spending it as fast as they could make it.
Another more savvy type of health insurance buyer just wanted coverage in case anything happened that could wipe them out financially. This type of person was normally in the higher income brackets. They wanted to spend as little as possible on their coverage, but if they needed it, they wanted it to pay off. They did not mind if they had to pay the first grand, or maybe even a few grand. They just did not want to get stuck with a big loss!
Now, lets apply this analogy to our stock and ETF investments. We can normally get "out of the money" put options for a very small price. Of course, the longer we want the coverage, the more the puts are going to cost.
Here is where a little strategy and savvy come in. I like to buy stocks that pay dividends. I want the stock to be a great investment too, I'm not buying it JUST for the dividend. I want a good stock that pays a nice dividend. This way, I'm looking for growth in the stock price, and I get paid a little each quarter too!
Since each put normally covers 100 shares of stock, I buy my stocks in lots of 100. Then I just need 1 put for each 100 shares of stock.
I also look for stocks that pay more than enough to cover the puts I want to buy on the stock. If I use this strategy I don't guess what the market might do, I assume it could pull back and eat my lunch at any moment (if I really don't think that could happen, I don't buy puts at all on the stock) and just buy the put options.
You also need to use some strategy when you get out of your puts. If you bought them close to the money, you may be able to sell them before expiration and get some of the money back. If I do this, I have some longer-term puts in place before I sell my shorter-term insurance (I want to be covered at all times as I know the market can tank or do anything at any time).
The trickier part is how you handle your trade when the stock does indeed take a dive on you. You could immediately sell when your put is in the money, but then the price may bounce and you will be upset that you did not leave your stock on the board.
The best scenario is that you sold your stock while it was still fairly high (and right after you received the quarterly dividend), and then you used the profit on your puts to buy the stock back toward the bottom, to ride it back up (with even more shares than you originally had). However, that is a hard one to pull off.
The easier plan is to just keep your stock open. You are still getting your dividends, and you use the profit from your puts to buy more stock (cost average) toward the bottom.
Compare that with someone who just suffered the loss and then hoped and prayed that it would come back to where they originally bought the stock. Chances are they will jump out as soon as they are even (if they ever are), and miss the real profit on the top.
I'm looking for good stocks that I want to hold for a long time, maybe even forever. So, buying a little insurance with cheap out-of-the-money puts is a way to keep me in the game and increase my position no matter what the market does. If my stock just keeps going up, and I never have to use the insurance, I'll just be happy to have my health!
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Doug West has been teaching traders for over 10 years. He has thousands of students from all walks of life and from all over the world.
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