How to Buy Insurance On Your Stock Positions

Member questions frequently drive S.A.F.E. Insights and this week's is no different. With the market at all-time highs, but the underlying economy still in question, many people are wondering if they can protect their positions that have in many cases restored their wealth. The answer is yes, you can insure your positions and it is not that difficult.

The free-markets have existed for many centuries and over that expansive history, investors, bankers & brokers have devised an endless stream of investment possibilities. From the earliest days under the Buttonwood Tree (that's a tree in New York where the Exchange started) investors buying public stocks looked for ways to guarantee their stocks future price, even if the future price dropped. Agricultural people have been doing this for a very long time. Farmers can lock in prices on their crops long before they harvest them and sell them by using the futures market. Well stock investors can do the same thing.

Let's think about the nature of insurance. You cover your life's various risks by buying an insurance contract in which you pay a premium to someone who guarantees you that in the future, if things go against you, a flood, a tornado, an earthquake, etc., that insurer will make you whole and restore your value to the current level. In most instances, the seller of the insurance (or writer) doesn't have to pay. If I buy earthquake insurance and there's no earthquake, the writer of the insurance keeps my premium; but if an earthquake hits, the writer of my insurance is required to pay me whatever value the contract calls for. Virtually all of us have insurance of one sort or another; auto, health, life disability, etc., but most professional investors have insurance on their stocks when things look volatile.

So let's translate that to stocks. For example, I own ABC Stock that presently is priced at $50.00 per share. I'm quite nervous about that price because it's only recently that it came back from its' low price of $25.00 and now that I'm whole, I don't want to lose it again. But, I don't want to sell it because I think it can go higher. This is where insurance comes in. The United States has the most developed and liquid markets in the whole world. One of the many advantages of that is that our markets offer very liquid insurance in the form of a "put." A "put" is a contract between you (the buyer) and the writer (seller) of the put. You want your $50.00 price assured but you think it could go higher. In such a liquid market as ours, there are always different opinions, so you find a person who thinks the $50.00 stock may go down. Because they think it will go down, they are willing to risk a price drop from $50.00. So you buy from this person a put contract that says you can "put" or sell your stock to that person for $50.00 at some point in the future. So you can now rest easy knowing that you've bought insurance on that stock; that if it drops to say $45.00 you can still put it to this person at $50.00. If the stock goes up, you keep your gains because you still own the stock. Pretty neat huh.

There is a downside though, while there is absolutely NO stock risk to buying a put like this, you do risk in a sense, 100% of your premium. It's like auto insurance, if you never have a crash you've "wasted" the premium. Same here, if the stock doesn't drop, you've "wasted" the cost of the put. Puts can be bought in various time segments, there are three, six, and even 12 month or longer contracts. The thing you have to understand is that the cost of these options is fairly priced generally speaking because there are lots and lots of options buyers & sellers and the market is relatively efficient. So you're not getting a "free lunch" here, but you are protecting your value.

When you become comfortable with buying puts, there is always the other side, selling calls. We'll write about how that can increase your income another time.

at 7:35 PM
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