If you buy a put option on a stock, you have the
right to sell shares of that stock at the option's strike
price, provided you act before the option's
expiration date. An investor who has sold a put option on that stock
must buy your shares.
If you exercise your right because the market price has dropped
below the strike price, you can sell the stock for more than you
could sell it for on the stock market. Or, if you prefer, you
can close out your position by selling the option to another investor,
sometimes for more than you paid to buy it. Either way, you limit
your potential loss on the stock because you put some money in
your pocket.
If you want to hedge your entire portfolio against significant
losses, you can buy a put option on an index that mirrors your
portfolio. If you exercise the option, you receive a cash payment
based on the strike price and the closing value of the index.
That amount should offset a portion of your portfolio losses.
Picking the right index
To use index options effectively, you must use the index that
most closely matches the portfolio or portion of the portfolio
that's at risk. If the index doesn't match, there won't
be a correlation between the value of your portfolio and the value
of the index.
Paying the price
One potential drawback of buying options is that they cost money
and last only a limited period of time, usually a matter of months.
Continuing to buy options to cover an extended period of time
can eat into the return you may realize from owning the stock
or stock portfolio to begin with.
But you can limit your financial exposure in a number of ways,
such as diversifying your options among industry groups and expiration
dates — the same core principle that applies to choosing
investments.
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates 
