Puts can help you protect profits on an existing position.

In my last post I explained buying puts as an alternative to short-selling when you're bearish. Today I want to dive into one of three common uses for puts, protecting profits on an existing position.

You buy stock because you're bullish and expect it to go up; chances are you aren't preoccupied with the downside. But as we all know, positions can shift on you quickly. Buying a put at the critical moment can help you lock in a run-up of profits in the event of a sudden reversal.

Let's consider an example. You bought stock XYZ at 50, and it rises to 100. Amazing, no? Then it drops slightly to 90. Hmm. Perhaps you say to yourself: when it gets back to 100, I'll close out and sell. But the stock drops further to 70. You might be revising your target to 80, but before you know it, the stock's back down to 50, and you've lost the entire run-up of potential profits. Sound familiar?

We've all been there: a stock makes a sudden run, you get excited and maybe a little greedy, but then it reverses before you can lock in the gain. Now consider this slightly revised scenario: when the stock was at 100, you could've said to yourself: that's an amazing run, and I want to lock in some of those potential gains. You buy a 60 day put with a 95 strike price for a couple of bucks, giving you the right to sell at 95 for the given time period. When that reversal kicked in, you could exercise your put and sell the stock at 95, keeping the lion's share of your gains or simply sell your put for a profit, offsetting a large portion of the loss on the stock.

Buying a 95 put, instead of a 100 put, should save you considerably but still lock in most of those gains. Think of it in insurance terms: if you buy zero-deductible insurance, it usually costs a fortune. Even a small deductible lowers your premium costs substantially. That 5-point difference in the two strike prices should provide the same benefit here.

Of course, timing is everything. You may purchase the put and then it expires worthless before the stock reverses. If that seems like a waste, consider this: when you buy insurance on your house, are you sad your house didn't burn down before the end of the term? Hopefully the stock has increased enough to offset the cost of the put "insurance".

That said, buying a put carries risks like any other option purchase: if the stock stays above the strike you can lose the entire premium. If you renew your "insurance" after the first put expires by purchasing a new put, your costs can add up. As long as you're using puts judiciously and aware of the risks, though, they can offer a compelling hedge.

Tune in next week for use 4 for puts: cash-secured put selling.

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.