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Most everything you’ve heard about investing from the mainstream media, your mutual fund advisor and your tax accountant is a lie. You’ve been told…that the entire point of portfolio diversification is to mitigate downside risk yet when the market experiences the inevitable decline, every sector pushes significantly lower – and your “diversified” portfolio suffers as a result, [right? Well, there IS a better way.] Hear me out. Words: 895
So writes Andy Crowder (www.wyattresearch.com) in edited excerpts from his original article* entitled How Stock Market Insurance Can Protect You from This Decline.
This article is presented compliments of www.munKNEE.com (Your Key to Making Money!) and may have been edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.
Crowder goes on to say in further edited excerpts:
The idea of portfolio diversification began with an article by Harry Markowitz in 1952 and since then diversification has been the cornerstone of Modern Portfolio Theory and portfolio risk management. In fact, the entire “retail” sector of investing – including all mutual funds, all 401(k) managers, index investing, etc. – all grows literally out of that original diversification idea from Markowitz.
We have been taught to spread our investments across a healthy range of stocks in different industries to reduce our downside risk exposure. It’s as basic as supply and demand. The logic behind such an approach to risk management (a form of investment portfolio “insurance”) goes something like this: If the retail sector falters, another industry such as consumer staples may be immune to whatever plagued the retail sector…but, as you can plainly see from the chart below, when a bear market occurs – like the ones in 2002 and 2008 – it doesn’t matter what sector you choose. All sectors fail during significant downturns … and fail miserably.
It was roughly 21 years AFTER Harry Markowitz introduced his theory that real stock market insurance was brought to market and even though it’s been another 40 years since that advent, most investors STILL don’t know about the single best and easiest method of portfolio insurance. If you haven’t guessed yet, I’m talking about options.
Options were originally created to act as a form of insurance because options are just contracts to cover your stock holdings under very specific circumstances…. Most investors use options for speculation, however, and that’s why options tend to get a bad rap as risky investments – but it doesn’t have to be that way….
Let me explain how options work using the following example:
1. You own 100 shares of the Retail Holders Trust (RTH) at $46.
2. Recently, the overall market and RTH have pushed into an intermediate-term overbought state such that you suspect that the market will witness a decline over the next few months that could exceed 10% and will likely affect the retail sector similarly.
3. If you are moderately bearish you can use vertical spreads and if you are mildly bearish you can use sell out-of-the-money calls. If you are very bearish, however, and think a sizeable correction is around the corner, you will want to protect a good portion of your returns from the recent rally.
4. To protect (insure) your gains you can buy one June put contract at the 42 strike on RTH. This option gives you the right to sell your 100 shares for $42, no matter how low the share price drops before the option expires in June (June 21).
5. Since the put option at the 42 strike is out of the money (the strike price is below the current share price), you can buy a June 42 RTH put for $0.65, or $65 per contract. You are now hedged – or insured – against losses below $42 for a cost of only $65 on a portfolio that has a value of roughly $4,600. Easy, right?
6. The extra $65 spent on the RTH put is the cost of protection, or insurance. Thus the cost to insure your $4,600 investment is $65, or only 1.4%.
7. The put is more than just an insurance policy, however.
a) If RTH goes up to say $56, you will have a profit of $935 ($1,000 increase in the shares less the $65 for the put insurance. (Of course your profit would have been the full $1,000 had you decided not to hedge your investment.)
b) If, however, RTH falls to say $36, or roughly by 22%, your loss will be limited to $400 because your put gives you the right to sell your shares for $42. Had you decided not to protect your portfolio, your loss would be $1,000. The small $65 cost of protection doesn’t look so bad now, does it?
8. You could limit your loss to only 5%, or even nothing, if you wish. Just pick a strike price that’s closer to the current RTH price. That’s a wonderful aspect of options – you can create your own risk profile.
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I hope that you picked up a few tips on how to protect your portfolio. You might be a trader or a buy-and-hold investor. Either way we all want to protect our capital – and using options is one of the most effective ways to do so…
Editor’s Note: The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://www.wyattresearch.com/article/how-stock-market-insurance-can-protect-you-from-this-decline/29486 (Andrew Crowder is Editor and Chief Options Strategist of Options Advantage and The Strike Price; ©2013 Wyatt Investment Research & Business Financial Publishing LLC; The Options Advantage service is available for a 2-month trial period at just $39 total and you can cancel at any time during that period and receive a FULL refund, no questions asked; I recently put together a video on 3 income strategies that can benefit from a falling market which you can watch here.)
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