Investment and Options Strategist
Summary: In this introductory guide, we cover the basics of using put options to protect your gains from the "Magnificent 7" tech stocks. Using MSFT as a case study, we detail how to choose options and illustrate their benefits in offsetting stock declines without selling your shares.
As investors in some of the most dynamic companies of our time, the "Magnificent 7" tech stocks, you've likely seen impressive gains in your portfolio. However, in the ever-volatile landscape of the stock market, it's crucial to protect those profits. For those of you with little to no experience in using options, we're here to guide you through straightforward hedging strategies that can serve as a safeguard for your investments.
This two-part article series will introduce you to the concept of using long put options as a form of "insurance" against downturns in stock prices. In our first installment, we'll use Microsoft (MSFT) as a demonstration case to illustrate how purchasing put options can help lock in the value of your investments. In the following article, we'll expand this approach to cover all of the Magnificent 7 stocks, discussing potential expiry dates and strike prices to consider.
You can find part two of this series here: Investing with options - Securing your tech stock gains with simple hedging strategies - 2of2
Important disclaimer: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
Put options are contracts that give you the right to sell a specific stock at a predetermined price before a set expiration date. By buying a put option, you're essentially purchasing insurance for your stock; if the stock price falls, the put option increases in value, helping to offset the loss in your portfolio.
The above screenshot shows an options chain for MSFT, displaying various strikes and expiries. It's a visual representation of the choices available to you when purchasing put options.
When buying put options, it's crucial to understand that one option contract typically covers 100 shares of the underlying stock. For example, if the price listed for an option is $21.50, that's the cost per share. Therefore, the total cost to buy one contract, which covers 100 shares, is 100 times that price—coming to $2,150 in total. This detail is clearly shown in the order ticket screenshot where the premium for one contract is stated.
To view this order ticket yourself, simply click on the ask price of the desired strike in the options chain. This action will bring up the order ticket, providing you with all the details you need to review before making your purchase, such as the total premium cost for the number of contracts you're considering.
As an investor, you have the autonomy to decide how many contracts you wish to purchase. A practical rule of thumb is to base the number of contracts on the amount of your stock holdings: divide the total number of shares you own by 100 to determine the corresponding number of contracts for full coverage. However, you are not bound to match contracts to shares on a one-to-one basis. Depending on your risk tolerance and coverage goals, you may opt for fewer contracts as a partial hedge or buy additional contracts to extend your protection.
When considering the purchase of multiple contracts, such as 10 for instance, a strategic approach could be to phase in your purchases. This technique, known as "laddering," involves buying a portion of the total number of contracts initially—say 4 contracts—and then purchasing additional contracts over time, such as another 4 after a few days and the final 2 at a later date. This method allows you to potentially benefit from price movements. If the market continues to rise, you may acquire subsequent contracts at a lower premium. Laddering can be customized to suit your strategy, whether that's 2 now, 2 later, and so on, allowing for flexibility in managing your investment "insurance."
Choosing an expiry date for your option is a balance between cost and the duration of protection. A longer expiry provides more time for the option to work but comes at a higher premium, while a shorter expiry costs less but also protects for less time. Similarly, selecting a strike price is about finding the right level of protection for your investment at a cost that makes sense to you.
Let's simulate the benefits of put options with MSFT trading at $404.83:
An important aspect to remember is that options offer flexibility. You don't have to exercise them, which would involve selling your MSFT stock. If you believe the stock price will rebound, you can choose to sell the put option itself at its increased value. This way, you can profit from the option's appreciation due to the stock's decline while retaining your shares in anticipation of a market recovery.
Utilizing put options is a smart way to protect against the downside without committing to selling your underlying shares. With MSFT as our case study, we've demonstrated how put options can serve as a strategic tool to shield your investments. Stay tuned for our next article, where we'll showcase how these principles can be applied to each of the Magnificent 7 stocks, giving you a comprehensive view of how to secure your tech stock gains in uncertain times.
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This article may or may not have been enriched with the support of advanced AI technology, including OpenAI's ChatGPT and/or other similar platforms. The initial setup, research and final proofing are done by the author.
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