One of the most common techniques in the stock market is buying leaps to protect you from the downside of the market. This can be used like sort of a long term insurance policy.
Let us look at how this works. Let us say you own a stock that is trading at $107. The markets have been a little volatile lately and you are worried that the market might crash along with your position.
To protect yourself you buy a $100 leap for $30. This gives you the right to sell the stock at $100 for 1 year. Now if the markets crash and your stock goes down to $40 you can still sell it at $100 because you bought the right to sell it at $100.
Now let us say that the market didn’t crash but instead started to stabilize and head up. Your stock went to $120. Now your leap is only worth $15. You would have two choices in this case. You can either leave the put alone and continue to have a protection level at $100, or if you feel like the markets are heading higher you can sell your $100 put for $15. This allows you to receive back some of the premium you spent on protection.
Buying leaps is definitely a helpful way to protect yourself from the downside but why would you buy them over short term put options they do the same thing and cost less. Let’s look at that.
Now let us say that you did not want to buy the $100 leap but the $100 put instead. The $100 put only cost $5 but only gives you protection for one month. If after that month is over the market is still scaring you, you would have to buy another $100 put for the next month.
So, you can wind up paying $5 a month per share for protection as long as you feel the market is uncertain. With the leap you would only pay $2.5 a month because $30/12= $2.5. This could be helpful if you want to protect yourself over a longer period of time.
For more information on buying options for downside protection visit http://www.stocks-simplified.com/protective_put.html
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