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I have a few stocks on my portfolio that I still like and I still believe I should own. They still meet all my buy signals, so I will still buy them today.

However, the stock market is not doing very well, and I am worry about a downturn. What is the best way to protect this asset from a downturn?

What is more effective, buy an option contract or sell the stock if it meets certain criteria?

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3 Answers

If you really believe in the particular stocks, then don't worry about their daily price. Overall if the company is sound, and presumably paying a dividend, then you're in it for the long haul.

Notwithstanding that, it is reasonable to look for a way out. The two you describe are quite different in their specifics.

Selling sounds like the simpler of the two, but the trigger event, and if it is automatic or "manual" matters. If you are happy to put in a sell order at some time in the future, then just go ahead with that.

Many brokers can place a STOP order, that will trigger on a certain price threshold being hit. Do note, however, that by default this would place a market order, and depending on the price that breaks through, in the event of a flash crash, depending on how fast the brokers systems were, you could find yourself selling quite cheaply.

A STOP LIMIT order will place a limit order at a triggered price. This would limit your overall downside loss, but you might not sell at all if the market is really running away.

Options are another reasonable way to deal with the situation, sort of like insurance. In this case you would likely buy a PUT, which would give you the right, but not the obligation to sell the stock at the price the that was specified in the option. In this case, no matter what, you are out the price of the option itself (hence my allusion to insurance), but if the event never happens then that was the price you paid to have that peace of mind.

I cannot council a specific course of action, but hopefully that fleshed out the options you have.

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Of the two, an option is a more reliable but more expensive means to get rid of a stock. As sdg said, a put option is basically an insurance policy on the stock; you pay a certain price for the contract itself, which locks in a sale price up to a particular future date. If the stock depreciates significantly, you exercise the option and get the contract price; otherwise you let the contract expire and keep the stock. Long-term, these are bad bets as each expired contract will offset earnings, but if you foresee a near-term steep drop in the stock price but aren't quite sure, a put option is good peace of mind.

A sell stop order is generally cheaper, but less reliable. You set a trigger price, say a loss of 10% of the stock's current value. If that threshold is reached, the stop order becomes a sell order and the broker will sell the stock on the market, take his commission (or a fixed price depending on your broker) and you get the rest. However, there has to be a buyer willing to buy at that price at the moment the trigger fires; if a stock has lost 10% rapidly, it's probably on the way down hard, and the order might not complete until you realize a 12% loss, or a 15%, or even 20%. A sell stop limit (a combination stop order and limit order) allows you to say that you want to sell if the stock drops to $X, but not sell if it drops below $X-Y. This allows you to limit realized losses by determining a band within which it should be sold, and not to sell above or below that price. These are cheaper because you only pay for the order if it is executed successfully; if you never need it, it's free (or very cheap; some brokers will charge a token service fee to maintain a stop or stop limit). However, if the price drops very quickly or you specify too narrow a band, the stock can drop through that band too quickly to execute the sell order and you end up with a severely depreciated stock and an unexercised order. This can happen if the company whose stock you own buys another company; VERY quickly, both stocks will adjust, the buying company will often plummet inside a few seconds after news of the merger is announced, based on the steep drop in working capital and/or the infusion of a large amount of new stock in the buying company to cover the equity of the purchased company. You end up with devalued stock and a worthless option (but one company buying another is not usually reason to sell; if the purchase is a good idea, their stock will recover).

Another option which may be useful to you is a swaption; this basically amounts to buying a put option on one financial instrument and a call on another, rolled into one option contract specifying a swap. This allows you to pick something you think would rise if your stock fell and exchange your stock for it at your option. For example, say the stock on which you buy this swaption is an airline stock, and you contract the option to swap for oil. If oil surges, the airline's stock will tank sharply, and you win both ways (avoiding loss and realizing a gain). You'd also win if either half of this option realized a gain over the option price; oil could surge or the airline could tank and you could win. You could even do this "naked" since its your option; if the airline's stock tanks, you buy it at the crashed price to exercise the option and then do so. The downside is a higher option cost; the seller will be no fool, so if your position appears to be likely, anyone who'd bet against you by selling you this option will want a pretty high return.

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Adding on to all the fine answers, you can consider selling a covered call. You will have to own a minimum of 100 shares.

It will offer a bit of protection, but limit your upside. If your confident long term, but expect a broader market pull back then a covered call might give you that small protection your looking for.

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Selling a covered call would yield some option premium income, but the short call position wouldn't limit downside risk on the underlying stock position. If the stock goes to zero, you lose everything other than the option premium collected. –  Chris W. Rea Aug 31 '12 at 11:52
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