How to Use Options as Insurance
- 1). Find a stock that you would like to buy because it is in an uptrend. Do this by looking at the weekly charts for the last three months. Draw a trend line across the lows and another line across the highs. This will create a channel. If the channel is slanting upward, you will want to buy this stock at a price somewhere near the bottom of the channel.
- 2). Make sure the stock is trading above its 200-day moving average. This is an indicator that professional traders use to decide whether a stock is bullish or bearish. If it is bullish (going up), then it will be trading above the 200-day moving average.
- 3). Buy 100 shares of the stock. This is the minimum number of shares you will need to buy in order to write a covered call. Each options contract controls 100 shares of stock.
- 4). Sell (also known as writing) a call option that is out of the money. For example, if you buy 100 shares of a stock for $50 per share, you will pay $5,000 plus transaction fees. You can then sell a call option, with a strike price of $60, for $150 per contract. This brings your total costs down to $5,000 minus $150, or $4,850, producing an immediate 3 percent return on your investment.
Watch the stock price. If the price stays flat, you will keep the $150 and still own the stock. If the stock price rises by $5, you will earn $5 x 100, or $500, plus the $150 from the sale of the call, for a total of $650. If the stock price falls by $1, you will lose $100 but you'll still have the $150 from the option sale, for a net gain of $50. The only scenario in which you will begin to lose money if the stock price falls by more than $1.50. - 5). Hedge with a put option. Another method of using options as insurance is by purchasing a put option. This will allow you to make money if the stock falls, which will offset your losses. For example, you buy 100 shares of a stock at $50 per share. You then buy an out-of-the-money (a contract that is far below the current stock price) put option with a strike price of $40. Let's say the stock fell to $45, which means that you have lost $500 ($5 x 100). However, the value of your put rose by $200, which leaves you with a net loss of only $300. Again, this method will reduce, but not eliminate, your losses.
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