Protect your Shares

Submitted by Stock Market News on 1 June, 2011 - 14:22

How to protect your shares from falling prices

When a share falls in value, traders will either sell to cut their losses. They may incur a capital gains tax in the process, and miss the opportunity when the price recovers. Fortunately, you can use options to protect your investments. You don't need to sell, and still benefit from a rise in share price. With a put option, your shares are protected no matter how low the share price drops. Its a hedging strategy that enables you to compensate by making money in one market when you lose in another. Your put option offsets the risk of your share position.

How does it work?

In case the share price falls, your put option's value will increase. The lower your share price is at the expiry, the more your put option will grow.

On the other hand, if the share price increases, you will still benefit from it. When your put option loses value, your shares increase. More importantly the loss that you will incur from your falling put option is limited to the premium you paid, while there is no limit on the growth of your shares. So the higher the share price increase the more money you make.

Calculating your profit:

You have to take into account both your option and stock positions first.

  • Your profit/loss on the option at the expiry is the difference between the its intrinsic value and the premium you paid.
  • Your profit/loss on your shares is the difference between the share price at expiry and the share price at the time you entered.

Then you add the two variables to get your net profit/loss.

At the expiry date:

In this strategy, unlike in other methods in options trading, the trader actually profits better when the option expires worthless.

Using options as a form of insurance when trading shares is beneficial in case the market goes downward. You have limited loss and stand to make unlimited profits as your shares increases when the price recovers.