During a sustained bull market, investors often search for ways of insulating their past gains from a possible market break. Even when fundamental economic factors tend to support a continued market expansion, investors have to watch out for unpredictable "technical market corrections" and market overreactions to news.

Selling stocks to reduce downside exposure is inefficient because it sacrifices potential price gains. Also, the transaction costs of quickly moving in and out of stocks as the market changes are exorbitant. What is desirable in a fluctuating market environment is an inexpensive financial instrument that protects the value of a portfolio against a market drop but does not constrain upside participation. Like the previous example, this is precisely what put options are designed to do.

Scenario: The market is still in an uptrend in August. Signals about inflation, employment, and economic growth continue to be generally favorable yet there is lingering uncertainty. Market participants are already questioning whether inflation will pick up and the Federal Reserve will tighten short-term interest rates further in the coming months. You have $78,000 invested in the DJIA portfolio, and the DJIA is at 7800.

Strategy: Purchase a put option on September futures as a way of insuring your portfolio against a possible market downturn. The put you purchase will reflect the extent to which you believe the market may fall and your risk tolerance if your opinion is incorrect. You decide to buy a 7600 put at a premium of 6.60. Your cost is $100 x 6.60, or $660.00.

Results: Buying the put places a floor on the value of the portfolio at the strike price. Buying a put with a strike price of 7600 effectively locks in the value of your portfolio at $76,000. Above its strike price, a put is not exercised and the portfolio value is unconstrained. If you are wrong, and the market goes up, you are out of pocket the premium paid for the put. Depending on which strike price you choose, you increase or decrease your downside risk. You break even when the September futures contract reaches a value of 7534.00 (7600 - 66.00). At this point, the unprotected and put-protected portfolio are equally profitable.

Comments: For different strike prices relative to the underlying futures, put options give partial or total protection from possible market breaks with no need to sacrifice the profit from additional stock price advances. You can elect to protect all or only part of your portfolio and can choose the strike price in accordance with your market forecast and risk tolerance.