Protect Your Portfolio With One Simple Trade

Original post

I have a love-hate relationship with insurance. I love having it, but I hate paying for it! Somehow I always seem to end up on the short end of the equation. Most people I know feel the same way. But deep down, you and I both know that insurance is important to have in case that low-probability event occurs.

In fact, it’s critical to have in most areas of your life… including your money.

There are two types of insurance for your stock portfolio.

The first is for the major crashes. Think of these as “Armageddon cases,” which occur every few decades (the last two were 21 years apart in 1987 and 2008).

For these, the only type of insurance that you can really buy is cash or cash-like instruments like bonds, especially government ones. You may want some gold in there too, but judging by the performance of gold during the 2008 crash, it wasn’t much of a safe haven. You could also short individual equities, betting on a fall. But that carries very high risk if those equities don’t fall in price and instead head higher. Shorting individual stocks opens up the possibility of unlimited losses.

The second type is insurance for the run-of-the-mill corrections (we’re talking 5% to 20%), which tend to occur once every couple of years.

For these, I prefer using put options on the major indexes – I am most fond of the Nasdaq and the S&P – to hedge my bets. For the Nasdaq, you can use the PowerShares QQQ ETF (Nasdaq: QQQ), which covers the stocks in the Nasdaq-100 Index. For the S&P 500, you can use the SPDR S&P 500 ETF (NYSE: SPY).

Let me show you how this would work.

First, we need some assumptions. Let’s assume you have a $500,000 stock portfolio. You expect the market to correct by 15% by the end of this year. That would result in a hit to your portfolio of around $75,000.

You would look at the SPDR puts that expire in December. The current price of the “at the money” puts (with a strike price that matches the current S&P 500’s price) is around $8 per share ($800 per contract). This means you have the right to sell the S&P 500 Index at the current price, which – as I write this – is 285.

If the S&P 500 were to fall 15% from the current levels, that would result in a fall of 42 points. If you purchased 10 contracts (costing $8,000 at current prices), your option would be worth $42,000 after that drop. Subtract your cost of $8,000, and you’d have a net gain of $34,000 to offset part of your $75,000 loss. If you bought 20 contracts, that number would jump to $68,000, almost offsetting the entire loss.

Your cost for the insurance at $8,000 would be about 1.6% of your portfolio’s worth. At $16,000, it would be 3.2%. The rub is that if the market doesn’t fall at all, that money would basically be toast. Of course, any fall of more than 3% would result in gains. It’s up to you to decide how much protection is enough.

The flip side is that if the market doesn’t correct but instead moves higher, you would need a gain of only 1.6% to 3.2% on your portfolio to recoup the price of the insurance.

Having portfolio insurance makes sense in periods when the markets look overvalued or toppy by historical standards. And having that insurance ensures a better night’s sleep as a bonus!

Good investing,

Karim