Here’s the full article I wrote for MarketWatch on using puts to hedge or protect your portfolio:
(or you can select this link to the MarketWatch article: http://on.mktw.net/WwNPvY
Put Up or Shut Up
Commentary: Stop scaring investors with gloomy predictions—and buy puts
As the Dow flirts above 14,000, many journalists warn about an impending crash. There are dozens of reasons why the market should not go up, but the market still does. One day the journalists will be right, but until then, they should put their money where their mouths are…with put options.
Like many people, 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 put my mind at ease.
The answer is put options. As you may know, options have had a bad reputation going back to 1635. That’s when greedy Dutch townsfolk sold naked puts on tulips. As more people participated, the price of a single tulip bulb went as high as $200,000 each (using today’s exchange rate).
Eventually, tulip prices plunged, and many people went bankrupt, helping to destroy the Dutch economy. Rather than blaming themselves for using exotic strategies on exotic flowers, investors blamed options. Even now, some people say that options are too risky and complicated. Unfortunately, selling naked put options on tulip bulbs (or using any strategy you don’t understand) is crazy. Buying puts, however, is entirely different.
Put your best foot forward
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 SPY (an ETF index based on the S&P 500.) You can also buy puts on ETFs based on the Dow Jones Industrial Average (DIA), Russell 2000 (IWM), and the Nasdaq 100 (QQQ).
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 approximately 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 or two, a year, all the way up to three years.
Here’s what it means: Although you won’t get 100% protection, in case there is a correction or 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.
Let’s look at what this strategy costs.
Put your thinking cap on
Only you can decide if the cost of put protection is worth it. Like any insurance, it’s not cheap. As of March 6, 2013, 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 ten 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 $2424 ($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.
Exercise: 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 put all your eggs in one basket
If you’re a journalist warning of an impending crash, consider buying puts to hedge against your own fears. If you’re a beginner, don’t go out and buy puts if you’ve never traded them before. Start by reading my book, Understanding Options, or other option books. 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.
Stock idea of the month
Last month, Amy Smith, author of How to Make Money in Stocks Success Stories, used the Can Slim® Investing System to choose Lumber Liquidators (NYSE: LL) as a stock idea. At first, LL went from $58.93 (when it was first mentioned in my column) to $65 (the day earnings were announced two weeks later). It dropped as low as $54 on the one-day stock selloff, and is now trading at over $60 per share.
Smith’s newest stock idea is HomeAway (Nasdaq: AWAY). This company, which is the world’s leading marketplace for vacation rentals, had its IPO debut in July 2011. Smith says this stock fits CAN SLIM Investing.
“The earnings in the most recent quarter were up 100%,” she says. “Those triple digit numbers captured the interest of institutional investors. The stock shot out of price consolidation on very big volume. When a stock gaps up with that much volume (491% above average), institutions have picked up shares.”
So should you run out and buy this stock? In Smith’s opinion, no. “Earnings come out on April 24th,” she says. “Although HomeAway is a little bit extended right now, you can look for a new entry point. If there is a pullback, however, it must be on low volume.”
As long as the stock pulls back on low volume, it means institutions are holding on to their shares, Smith says. “If it’s on high volume, it means that institutional investors are selling.”
Note: To read more about what Smith has to say about HomeAway and Lumber Liquidators, visit www.michaelsincere.com.
Michael Sincere www.michaelsincere.com is the author of “Understanding Options,” “All About Market Indicators,” and “Understanding Stocks.” Note: Michael Sincere and Amy Smith did not buy shares of HomeAway before this column was published.