How to Lighten Stock Losses

 | Oct 17, 2011 | 4:08 PM EDT  | Comments
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Stock quotes in this article:

atpg

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aig

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aapl

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cmg

There is a simple way to help lessen the loss potential of owning stock: buy a put option. Buying a put protects your downside and it is easy to implement. In fact, buying a covered put may be the most basic way to protect individual stocks from losses. Market volatility has come down significantly over the past few weeks and since greater volatility leads to higher option prices, now may be a decent time to consider buying some puts.

Anyone fortuitous enough to buy stocks late in the third quarter is feeling pretty good right now. ATP Oil and Gas (ATPG), a stock I suggested would be a great buy below $10 a share, fell below $7 a couple of weeks ago. The shares are now trading near $11 -- a tidy 50% gain. Even though the company is highly leveraged, the company's proven reserves and production potential make ATPG a very interesting energy bet. Even at current prices, the value is acceptable. You can buy the March 2012 $6 puts for about $0.85 (this excludes the article commissions, but they should be considered). The put sale gives you about five months of downside protection in the event the stock, or the market, has another severe selloff

The protection doesn't come without a cost, however. If ATPG drops to say, $7, by March, your puts will expire worthless. You will have suffered the $1 per-share put premium and depending on your purchase price, a possible capital loss. It's not wise to buy puts at strike prices close to the current stock price. At a $10 strike, the same put will cost you nearly $2.50, nearly 25% of ATPG current share price of $10.65. If the stock falls to $8, the put is worth $2, a loss of $0.50. In this case buying a put was useless

Therefore, one should only contemplate buying puts to protect longs against a sharp pullback against a security. You also buy a put knowing that you could lose the entire premium. It's like insurance: You pay a premium regardless of whether or not you incur a loss. As my rule of thumb, I would not spend more than 5%-10% of the equity value for about a year's worth of insurance. In other words, for a $100 stock, pay no more than $5 to $10 a year for the right to own that put. But you also want a strike price that is realistic; paying 10% a year to protect against a 75% decline is likely to waste your capital -- not protect it. When volatility is high, owning a put may not be worthwhile.

So many investors are intrigued by the significant upside that today's financial stocks provide but worried about all the uncertainty surrounding the future. Insurance giant AIG (AIG) is trading for $23, a valuation many close followers say is well below the long-term intrinsic value of the business. The Feb 2012 $20 strike will cost about $1.50 a share. I would note that because financials have sold off significantly in the past few months, it may not be intelligent to implement this approach now. That said, a European financial catastrophe could quickly send shares down another 25% -- or even  more.

Rather popular names like Apple (AAPL) or Chipotle (CMG) may be more suitable. The growth story continues to look compelling for these names, so some may be inclined to take a bite at these levels (my recent visit to a Chipotle at 3 p.m. looked like a 12 p.m. lunch rush hour) but one "bad" quarter where profits grow by 10% instead of usual 20% or more could send shares down quickly. Chipotle shares trade for a spicy $324 or above 50x earnings. Because the strong growth story makes the shares tempting even at this price -- yet also opens to the door to a correction -- insurance is a suitable option. You can own protection until January 2012 at $270 for about $10 a share. But buyers beware: I think a lot of bad things have to happen to Chipotle to see that share price.

Buying puts on individual stocks should be evaluated on a case-by-case basis. Some who buy a truly undervalued stock will care little for buying puts since they are confident in its upside potential. But as we've seen in this uncertain market environment, prices can stay irrational longer than most people think. Always do the math to ensure that insurance obtained via selling a put is not costly to the point where the strategy is ineffective.

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