Limbo Time! How Low Can You Go?

Perhaps it's time to dust off your Chubby Checker Limbo Rock album and find a broom stick... It may be time to get low!

After an abysmal market performance on Monday (10/6), Mr. Market followed it up by falling another 5%. In fact, all three indices (Dow, NASDAQ, S&P) suffered 5-6% losses.

Needless to say, these brutal days on the street can be rough on us average investors. It's not fun to watch your stake in a company fall lower in value, day after day. That's why I invest with a long-term mindset, and I understand that short-term falls are not unexpected.

That being said, wouldn't it be great if there were a way to protect yourself from the short term losses. There is. They're called put options.

In markets as volatile as these, it sometimes pays to employ other trading techniques other than the simply buy and hold. That's not to say buying and holding won't work out in the long run. After all, that's what we're after. But why not protect your investment a bit and earn some money while you're waiting for the long run?

Simply stated, put options represent the "option" to sell a stock at a certain price at a later date. You don't need to own the stock itself, but you're agreeing that on XX/XX/XXXX, you'll sell shares of the stock at a set price.

An example: Let's say Google (GOOG) is trading at $345/share right now. You think that in the long run the share price will go up, but think in the short term the price may fall. In markets like todays, that's not a bad bet. So you can buy a put option contract which generally represents 100 shares at a certain price. For the March 2009 expiration date, you can buy a put contract at $39.50/share, with a strike price of $320.

This means that for $39.50/share, you're buying the right to sell 100 shares of (GOOG) at a price of $320/share, on March 20, 2009. It will cost you $3,950 to buy that contract (100x39.50). It's important to remember that options are just that, options. You have the option to sell those 100 shares, but are not required to.

In fact, the real value with options comes from its leverage. Let's say prior to March 20, 2009, Google's share price has dropped below $320/share. Your put option is now in-the-money and has gained in value. Now if you'd like, you can close your position, thereby forfeiting your right to sell those shares later down the road, but pocketing the profit.

I'll give you a real example from my own portfolio to explain better. I own shares of General Steel Holdings (GSI). Due to the growing global financial crisis, building slow-downs and a variety of other factors, the stock price is quite depressed lately. But I also own put options of GSI. I own put contracts for the November 2008 expiration date, with a strike price of $7.50. This means in November, I can sell my 100 shares for $7.50/share. It cost me $2.05/share to buy this, so roughly $215 per contract after commission.

Since I bought the contracts, GSI's share price has fallen quite a lot. However, this means my contracts have increased in value since my strike price is above the share price. While each contract cost me $205, minus commission, it is now worth $320/contract. If the share price stays low and the date for my sell option gets closer, the value will continue to increase.

Of course, there is the chance that GSI's share price could increase, and my option will lose value, but what do you think is most likely in the next two months? It's a rough sea out there, but there are still ways to make money. Think of put options as a way to protect your investment in a company.

As always, this isn't a recommendation for GSI or for its put option. This is also a very very brief introduction into one of the many ways to use options to invest. Options can involve greater risk and are not for all investors. I implore you to do your own research and talk to a financial advisor if you'd like. There are many financial professionals out there who know gobs more than I do. But I want to make sure you aren't running from the market with your tail tucked. More than 80% of the companies publically traded U.S. stocks are down this year. This includes solid companies like Apple and General Electric.

These current lows represent a great time to get invested into a solid company. Ask Warren Buffet. But also consider protecting your investment for these short-term downturns.


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