There Is A Cheaper Way to Lock In Profits

The rally in stocks since March has brought some much-needed relief to shellshocked investors who saw so much of their net worth go up in smoke during 2008. And if you're looking to take advantage of a strategy that could help you preserve most of the money you've recovered in the past two months, there's more good news: It's a lot less expensive to protect yourself than it was earlier this year.

One simple way you can guard against your stocks falling sharply in value is by buying put options. These options essentially guarantee that no matter how much your shares drop, you have the right to sell them at a price you determine within a certain period of time.

As you might expect, put options got expensive during both the November panic and the ensuing plunge in March. But now that a measure of calm has descended upon the market, you can buy puts much more reasonably.

The VIX and you
The volatility index, or VIX, is one measure that follows the relative cost of options. Because options pricing depends on volatility -- the more volatile a stock is, the more expensive the associated options will be -- looking at the VIX will give you a sense of how much you'll pay to protect yourself against market fluctuations.

After hitting historic highs last October and November, the VIX has turned downward. Many pointed to those lower levels as evidence that the March decline wasn't the true low for the bear market. Whatever the reason, current volatility levels haven't been this low since shortly before Lehman's bankruptcy in mid-September.

Grabbing your gains
If you want to hedge against giving up some of the gains you've seen in your portfolio over the last two months, you can probably now do so without spending quite as much. The VIX tracks options on the broad S&P 500 index, so some individual stocks may not have seen their volatility levels fall -- but it's likely that many have.

Puts on many stocks offer reasonable prices right now. Here's a sample of current put costs on some commonly traded stocks and ETFs.

Which option you should buy depends on how much protection you want. The May options listed for Microsoft and Wynn will only protect you for the next week and a half, but you can spend more to get an option that will last longer, if that's more in line with your investing strategy.

Speculating on security
Like most options strategies, buying puts involves substantial risk. If shares rise or even stay flat, you would lose your entire investment on most of the options listed above. In fact, if your option's strike price is below the stock's current value, you could actually see your shares drop and still suffer a complete loss on your put option.

You can look at put options the same way you do an insurance policy, though. If your stocks drop in the near future, paying around 3% or so of the current share price to limit your losses may well be worth the cost.

Still, the cost of long-term puts makes it expensive to get extended protection. As you can see from the SPDR put listed above, you'd pay almost 13% of the current stock price to limit your losses to $1.56 per share -- and even that option only lasts for seven months.

So don't expect to cover your downside forever using put options. But if temporary protection makes you more confident about taking advantage of still-attractive valuations on stocks, your future gains could easily dwarf what you spend on puts.

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