Insurance Against Market Correction

03/13/2013 8:00 am EST

Focus: OPTIONS

Michael Sincere

Author, Understanding Stocks

As the stock market climbs the wall of worry, those experiencing sleepless nights do have options (literally) to protect their portfolios, notes Michael Sincere of MichaelSincere.com.

I love the stock market, but I hate losing money. This is a serious problem because to make money, you have to learn how to lose. Because of fear, at times I've been out of the market during some of the strongest bull markets.

And then I found an answer, one that literally put my mind at ease.

The answer is put options. I wish I had learned earlier about the power of buying puts as a hedge against fear (and potential losses).

Here's one strategy I like: To protect my individual stocks and mutual fund positions (my long-term portfolio), I buy put options on SPDR S&P 500 ETF Trust (SPY), an ETF index linked to the Standard & Poor's 500-stock index. You can also buy puts on ETFs based on the Dow Jones Industrial Average, Russell 2000, and the Nasdaq 100.

For example, to help protect a $50,000 portfolio that invests primarily in stocks that track the S&P 500, you would need to buy around three put contracts. Next, you have to choose how long you want to keep the protection (it's called an expiration date). The longer the protection, the more it costs. You can choose a month, a year—all the way up to three years.

Here's how it works: Although you won't get 100% protection in a correction or a crash, as your stocks plunge, the value of your put option rises. It's like buying an insurance policy. You hope that the market doesn't crash, but if it does, your losses are limited. That should help put you to sleep.

Costs and Benefits
Only you can decide if the cost of put protection is worth it. Like any insurance, it's not cheap. As of March 6, three SPY put contracts with a $150 strike price (or 1500 on the S&P 500) that expire on June 22, 2013 costs $336 each (subject to change), totaling $1,008 plus commissions ($336 x 3 contracts). That's the cost for three months of protection. If the market crashes anytime before June 22, the put limits your losses.

Your risk: In this example, the most you could lose is $1,008, which is the cost of the three puts. Why three put contracts? Each put represents 100 shares. Since you have the right to sell 300 shares at $150 per share, that is $45,000 worth of stock.

If you wanted 10 months of protection for a $50,000 portfolio, as of March 6, a LEAPS put on the SPY with a $150 strike price that expires on January 18, 2014, costs $808 each (subject to change), totaling $2,424 ($808 x 3 contracts). That's the price you have to pay if you truly fear a market crash.

What are LEAPS? Their full name is Long-Term Equity AnticiPation Securities, and they are long-term option contracts, identical to standard options except for the longer time period (from nine months to three years) Your risk: Again, it is the cost of buying the options. In this example, the most you can lose is $2,424.

There is another complication when you buy puts. If SPY drops in price, and you have a winning put position on the expiration date, your option could be exercised. This means that your option is converted into a short position in SPY shares. This is not a sound idea. To avoid this from happening, sell your profitable put before the expiration date.

Don't buy puts if you've never traded them before. Start by reading books on options. Also, go on the Internet and visit the Options Industry Council (OIC) and Chicago Board Options Exchange (CBOE) websites, or take free classes with the OIC. You can also call your brokerage firm.

By Michael Sincere, Blogger, MichaelSincere.com

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