- The Washington Times - Tuesday, May 17, 2005

Q: How can I use equity option contracts to reduce risk in my portfolio?

A: If you hold individual stocks in your portfolio, you may be able to offer or accept options contracts that will hedge against losses or lock in profits. In essence, you can create insurance policies for your stock.

An option contract is an agreement between two persons to give one person the right, but not the obligation, to buy or sell the stock at a specified price, on or before an agreed-upon date. Options have become more popular, and many brokers, especially online discount brokers, are pushing options in advertising and on their Web sites.

Using options can get complex, however, and investors should consult with their brokers or financial planners before buying or selling options.

If you own stock, there are two kinds of options you can use to protect yourself against risk. The first is called a “protective put,” in which you pay someone else to buy the stock if it drops below a certain price — usually a price where you start feeling uncomfortable about its long-term value.

“Car insurance is a perfect analogy for this,” said Randy Frederick, director of derivatives at Schwab CyberTrader. “You’re paying a small premium in order to protect your investment. You won’t get the full price back — kind of like how you have a deductible on your car insurance — but you’ll get most of your money back.”

For example, let’s say you own 100 shares of XYZ, which you bought at $28. Perhaps you feel that the company’s quarterly earnings won’t live up to expectations, or the overall market seems to be heading lower. You pay 50 cents per share for a protective put on the stock at $25 — meaning that the person you paid will buy your 100 shares at $25 each.

The stock then falls to $20 after a terrible quarterly earnings report. You exercise your option, and the other person pays you $25 per share for your stock. You paid $2,800 for the stock, but instead of losing $800 by selling at $20, you lost $350 instead — $300 for selling at $25, plus $50 for the option.

If, however, you feel the stock won’t fall, but won’t skyrocket either, a covered call is a way for you to make a little money off a stock that would otherwise sit in your portfolio.

In a covered call, you sell someone else the right to purchase your stock at a higher price. If the stock rises beyond that price, the other person has the option to buy your stock at the agreed price. If not, then you’ve still made a little money by selling the option.

As with the previous example, you own 100 shares of XYZ, purchased at $28. You sell a covered call for those shares at $32 each, gaining $50. If the stock doesn’t rise to $32 — or if it falls — that $50 is yours no matter what, and the contract will expire without you having to sell the stock.

If the stock rises to $36, however, you’re still obligated to sell at $32, which means you’ll make $450?$400 in profits and $50 from the option — but you will have given up a potential $800 profit.

“Obviously, you’re going to write a covered call only if you think the stock is going to be flat or go up moderately,” Mr. Frederick said, “and only if the stock is at or above what you initially paid for it.”

There are other implications for a covered call, however. Naturally, an unexpected spike in your stock’s price means that you’ll end up selling for less than you might otherwise have. Furthermore, if the contract forces you to sell, you’ll likely have tax implications from the sale as well. On the bright side, you will have locked in a profit on your stock no matter what happens after that.

Options are generally written on a fixed schedule, expiring on the third Saturday of each month. You can write a put or call for any number of months as long as you can find a partner to agree to your time frame. If you opt for a protective put or covered call, your broker will take your option to exchanges like the Chicago Board of Options Exchange or the American Stock Exchange, where options contracts are bought and sold.

Again, options can be complex. You’ll need to know a great deal about the companies in which you hold stock before you decide how much profit or loss you’re willing to risk in an options trade. You should consult a financial professional before making any puts or calls based on your stock holdings.

ASSOCIATED PRESS

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