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.
How to Read Stock Market Indicators
Each month, I’ll review the top stock market indicators to find out what story they have to tell. You can learn how to read these indicators, as well as many others, in my book, All About Market Indicators (McGraw-Hill).
The idea is to use a number of indicators, not just one, to determine which way the market is headed. In addition, use the indicators as an early warning signal rather than to time the market. A market can remain in dangerously overbought territory for weeks, months, and even years before reversing.
What the Stock Market is Telling Us Now
The following market indicators monitor the sentiment, or psychology, of the market. These are contrarian indicators, which means you should do the opposite of what everyone else is doing. For example, if the indicator shows that everyone is buying stocks, you should consider selling. Do not use sentiment indicators to time the market, but only to measure what the crowd is doing.
American Association of Individual Investors (AAII): When investors are too bullish (over 60%), it’s a sell signal. When they are too bearish, (over 50%), it’s a buy signal.
Signal: The week of February 27th, investors were 28.4% bullish and 36.6% bearish. This is a neutral signal.
Investor’s Intelligence Advisor Sentiment Survey (II): When independent newsletter writers are too bullish (over 50%), it’s a sell signal. When newsletter writers are too bearish (over 50%), it’s a buy signal.
Signal: The week of February 27th, newsletter writers were 46.3% bullish and 21.1% bearish. This is a neutral signal. On the other hand, it shows that the independent financial media is more bullish about the stock market than the public right now.
CBOE Put/Call Ratio: This indicator tracks the volume of put and call options that trade on the CBOE. Because so many retail option speculators are often wrong, it’s a clue to do the opposite.
If the Put/Call ration is lower than .75 (more call options are being bought), it’s a sell signal. If the Put/Call ratio is higher than 1.0 (more put options are being bought), it’s a buy signal.
Signal: As of March 1, the Put/Call ratio was .67, which is a sell signal, but not as strong as last month (.55). This means that more individuals are buying call options on individual stocks because they are bullish about the market.
Note: Trader and author Martin Zweig was the first to use the Put/Call Ratio to identify tops and bottoms by betting in the opposite direction. Sadly, Mr. Zweig passed away last week at the age of 70. He will be missed.
Note: The International Securities Exchange (ISEE) also has an indicator, the ISEE Call/Put Ratio, which is also very useful.
Moving Averages are my favorite technical indicator because it tells you when a market trend has begun or ended. Basically, it keeps you on the right side of a trend. The most popular, and useful, moving averages are the 50-, 100-, and 200-day MA.
Signal: The moving averages are telling us the long-term market trend is still positive, although we had a bit of a scare last week. Looking at the three-month chart, the S&P 500 index is above all three of its moving averages.
Note: Moving averages are not designed to catch tops or bottoms, and are sometimes slow to react. They also don’t work well in choppy markets.
COMMENTS ABOUT THE MARKET
According to the market indicators, the trend is still positive. However, because of economic concerns, it would not be surprising to see a short-term pullback.
In my newest article for MarketWatch (will be published in a week), I’ll be discussing ways of using options to protect yourself if you are bullish about the stock market. To help you sleep at night, you can use options to insure your stock portfolio.
In addition, author Amy Smith will discuss her next stock idea using the CAN SLIM investment system. The last stock that Smith mentioned, Lumber Liquidators (NYSE: LL), performed brilliantly. It fit the strategy of the long-term trader, which means you can hold stocks and mutual funds long term, but also trade.
When Smith mentioned LL in my MarketWatch column, it was trading at $58.93 per share. When earnings were released, it shot up to $65. After the one-day stock market plunge of 130 points, LL dropped all the way to $54. It’s now at $60.70 and climbing. This is definitely a stock you could hold for the long term, but also use for short-term trades.
If you want to learn more about stocks and options, you can read my book, Understanding Stocks(McGraw-Hill), or Understanding Options (McGraw-Hill).
Here is my latest article for MarketWatch (February 6, 2013): http://on.mktw.net/12tTDYx
What the market indicators are telling us now
MIAMI, Fla. (MarketWatch) — Do we dare call this a bull market? The indicators were on target in January, and showed that the market had enough strength to go higher. Nevertheless, we’ll turn to the indicators to warn of potential dangers.
On the technical side, the Standard & Poor’s 500-stock index (SNC:SPX) is well above its moving averages, which indicate the bullish trend will continue. Obviously, a so-called Black Swan event can occur at any time, but after four years, we’re still waiting. The higher the market goes, the louder the crash warnings will get. But the market keeps advancing. MACD is also signaling that the upward trend will continue.
Meanwhile, the Relative Strength Index is signaling the market is overbought, which is a concern. However, the market can remain overbought for weeks or months before reversing.
Sentiment indicators, which tell you if investors are overly bullish or bearish, show that investors are becoming more enthusiastic about the market. The recent 0.67 put/call ratio hints that options investors are still bullish (and buying more call options). It wouldn’t be surprising to see the market have a short-term pullback, bringing investors back to reality.
CANSLIM sizes up stocks
Recently I had a talk with Amy Smith, author of How to Make Money in Stocks Success Stories , and an expert on the CANSLIM investment philosophy. I wanted to confirm that CANSLIM was showing what I see: a bullish market with possible warning signs. CANSLIM, created by William O’Neil, looks at current earnings, annual earnings, new products and services, share supply and demand, leaders and laggards, institutional sponsorship, and market indexes to identify strong and weak stocks.
Smith says that the overall market is continuing to act well, noting that “the Nasdaq (NASDAQ:COMP) is holding in a tight range.”
Because we’re in earnings season, Smith wants to know if institutions are starting to sell stocks, which would be a warning sign. If there is heavy selling, that would indicate mutual fund companies and other large players have lost faith in the market. Fortunately, Smith doesn’t see that yet.
Most important to CANSLIM, the leading stocks are still acting well, and so far there haven’t been major problems. Even though a few stocks (such as Apple Inc. (NASDAQ:AAPL) ) have had disappointing earnings, Smith says that happens every earnings season. Overall, according to CANSLIM, the market is acting strong but Smith is looking for signs of distribution (selling). The leading stocks are holding up, but she is watching them closely.
When I asked Smith for a leading stock that fits the CANSLIM criteria, she mentioned Lumber Liquidators Holdings Inc. (NYSE:LL) , a retailer that provides hardwood flooring and lamination at discounted prices. The company has profited along with the housing market recovery, and has a chart that any long-term investor (or covered call writer) might appreciate. Lumber Liquidators reports earnings on February 20.
Here’s why Smith likes Lumber Liquidators: “A lot of homebuilders are reporting earnings, which will tell us if the housing boom is continuing, or if there will be a slowdown from that group. Lumber Liquidators is a stock that has done well, and since October has been consolidating (a period of indecision). When they report earnings, we want to see if they can come out of this price consolidation on heavy volume.”
If the stock breaks out on strong volume, it would indicate that institutions are aggressively buying.
Because it is earnings season, the market may be volatile in the short term. Nevertheless, the indicators are generally positive, and unless there are unexpected surprises, February could be a good month.
Rather than get swayed by fear, rely on fundamental or technical analysis, or a method such as CANSLIM. If you do see danger signs, then sell or reduce your position. But staying out of the market permanently because the markets might crash is not an investment strategy.
Michael Sincere www.michaelsincere.com is the author of “All About Market Indicators,” “Understanding Options,” and “Understanding Stocks.”
This is my latest article on MarketWatch (below). And here is the link: http://on.mktw.net/VM78ML
How to follow stock-market money flows
Commentary: These market indicators are key to patterns and profits
MIAMI, Fla. (MarketWatch) — Rather than rely on emotions and opinion, which are frequently wrong, look at stock market indicators. Although not foolproof, indicators do give important clues as to market direction. They are also used to monitor long-term market conditions.
Here are the most reliable market indicators and their recent signals:
1. American Association of Individual Investors (AAII) : You can find the signals for this weekly sentiment survey at www.aaii.com/sentimentsurvey , or in a number of financial periodicals. The idea is to do the opposite of individual investors. When investors are too bullish (over 60%), it’s a sell. When they are too bearish (over 50%), it’s a buy.
Signal: The week of January 2, investors were 38.7% bullish and 36.2% bearish. Right now, this is a neutral signal.
2. Investor’s Intelligence Advisor Sentiment Survey : You can find this weekly sentiment survey at www.schaefersresearch.com or other websites. Similar to the AAII, Investor’s Intelligence surveys independent newsletter writers for their market view. If the newsletters are too bullish (over 50%), sell. If they are bearish (over 50%), buy.
Signal: The week of December 26, newsletter writers were 48.9% bullish and 24.5% bearish.
Note: A buy or sell signal doesn’t mean you react immediately. Sometimes signals remain in overbought or oversold territory for long periods.
3. CBOE Put/Call Ratio : Find the Put/Call ratio on the Chicago Board Options Exchange ( www.cboe.com ) or on charting software. This indicator tracks the volume of put and call options that trade on the CBOE. Because so many options speculators are wrong, it’s a clue to do the opposite.
If the equity Put/Call ratio is lower than .75 (more call options are being bought), it’s a sell signal. If the Put/Call ratio is higher than 1.0 (more put options are being bought), it’s a buy signal.
Signal: As of January 2, the Put/Call ratio was .55. This is a significant sell signal. If the Put/Call ratio falls below .50, it’s a screaming sell.
By the numbers
These market indicators give a running tally of stock highs and lows, or advances and declines. The most popular are the New High-New Low, the Arms Index, and the Advance-Decline Line.
All three recently showed buy signals. If more stocks continue to advance, and if the new high list expands, that would be a positive sign.
On the other hand, astute traders will also look for overbought or oversold signals. If these indicators reach extreme levels, and too many stocks are making new highs, it could mean excessive buying. That would be a warning.
Moving Averages: My favorite technical indicator is moving averages, which can be found on any stock chart. If used properly, they can help investors and traders stay on the right side of a market trend. It tells you if a trend has begun or ended.
Moving averages show you the value of a security’s price over the duration of a time period, such as the last 20-, 50-, 100- or 200 days. Placing the moving average over the stock market helps you determine market direction. The most popular moving averages are the 50-, 100-, and 200-day.
Signal: The moving averages are telling us the long-term market trend is positive. Looking at a three-month chart, the Standard & Poor’s 500-stock index (SNC:SPX) is well above its 50-, 100-, and 200-day moving average.
Keep in mind moving averages are not designed to catch tops or bottoms, and are sometimes slow to react. They also don’t work well in choppy markets.
My other favorite technical indicator is MACD, which is flashing a buy signal.
The January Effect and January Barometer
January is the most important month of the year for investors and traders. Many believe it sets the tone for the rest of the year. Let’s take a look at two January indicators: the January Effect and the January Barometer.
The January Effect, discovered by Donald Keim, says that when January is weak, it’s a bad omen. Conversely, if January is strong it could be a good year. It’s based on the idea that large institutions sell stocks at the end of the year for tax purposes and buy back in January. Unfortunately, the indicator has lost much of its effectiveness in recent years.
The January Barometer has been more reliable. Devised by Stock Trader’s Almanac ( http://www.stocktradersalmanac.com ) founder Yale Hirsch in 1972, the January Barometer refers to the returns of the S&P 500 in January. The theory: if the benchmark is up in January, it will be an up year. If the S&P 500 is down in January, the year will be flat or down.
Signal: We had a fantastic start to the year, but we won’t know the results of the January Effect or January Barometer until February 1.
What is the market telling us now?
Based on the above indicators, the market appears to be going higher. There is still plenty of pessimism, which is a positive sign for the market. The technical indicators are generally positive, and the market trend is up.
And yet, there are danger signals. Sentiment indicators are reflecting increased bullishness, which could turn into a negative sign. If investor disbelief turns into increased hope and optimism, the market will react positively; that is, unless the euphoria gets excessive. If I see obstinate market pessimists throw in their towels (and that could take years), it would tell me we’ve reached a tipping point.
Until then, keep an eye on the market indicators for clues. There are hundreds to choose from, but the ones listed here are the most reliable.
Each month, I like to do a market overview and see where the market might be headed. Although there are many frightening predictions, the indicators are actually looking pretty good. Here’s a brief list (which comes from my book, All About Market Indicators (McGraw-Hill, 2011).
AAII Survey: 40% bullish, which is neutral). Note: Over 60% bullish is a sell.
Investor’s Intelligence: 39.3% bullish, which is neutral. Note: Over 50% bullish is a sell.
Put/Call Ratio: .60 (This indicates more calls are being bought, which is slightly bearish (contrary indicator))
ISEE: 176, which is neutral. Note: Over 250 is a sell signal.
VIX: 15.35, which indicates calm among call and put buyers and sellers. Note: Under 12 is a sell signal.
New High-New Low: New highs are expanding, which is a positive sign.
Advance-Decline Line: Rising, which is positive.
Moving Average: The S&P 500 is above the 200-day MA, which is a positive sign.
According to the above indicators, the market signs are positive. Obviously, there could be short-term volatility because of the fiscal cliff negotiations.