Know your options if the stock market corrects
Commentary: Use protective puts to cushion the worst of a downturn
new
March 7, 2013, 8:03 a.m. EST
MIAMI (MarketWatch) — 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.
Dow record: Have new investors missed the boat?
Does the Dow have more room to run? Teddy Weisberg of Seaport Securities and Mark Luschini of Janney Montgomery Scott discuss. Photo: Getty Images.
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
+0.27%
(an ETF index linked to the Standard & Poor’s 500-stock index.
SPX
+0.25%
) You can also buy puts on ETFs based on the Dow Jones Industrial Average
DIA
+0.34%
, Russell 2000
IWM
+0.68%
, and the Nasdaq 100
QQQ
+0.13%
.
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.
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