Learn the tools to protect your portfolio, Part 1

May 3, 2010 / Jeff McAllister

Tool rack — Image by L. Marie via Flickr

How can I diversify and protect my portfolio?

I’m often asked, “How should I go about protecting my assets? Should I diversify across asset classes? Should I allocate large portions of my assets into annuities or insurance products?” With so much uncertainty in these times as we struggle to revive the economic engine, it is normal to be very concerned about the safety of your investments. The real trick is to understand methods that will protect your investments in any market environment.

So, let’s say that you have a portfolio made up primarily of equities, stocks like Apple (ticker:AAPL), Dow Chemical (DOW), Caterpillar (CAT), IBM (IBM) and United Health Care (UNH). Are you diversified? Is your portfolio at risk? Should I even be in stocks at this time? Well, from a traditional diversification model – you are somewhat diversified. You have equities from several different sectors. However, you are NOT protected from any sort of bearish or downward trend in the market place.

What about being more invested in Municipal bonds? Though the total yield of such investments is low, and even though they are considered “safe” investments, the risk is higher than it used to be (it’s not just the States who are in serious trouble!). So, how can you, as an interested and proactive investor, protect your portfolio? The real answer lies in an understanding of the use of options as a hedge in your investment activities.

Would you consider owning a home without insurance against loss? Probably not. How about a car? Do you have some sort of medical insurance? Most of us do. And yet, so few are aware that such an option (pun intended) exists for our investments. Like insurance, you get to choose the term and the amount of insurance that you would like to have. I’m referring to the “Put” option. Simply stated, the Put allows the buyer the RIGHT to sell the underlying equity at the strike price (think level of coverage) of the put for the life of the option (just how much time do you wish to have this insurance in place?).

Many of you will recognize this approach as the “Married Put”. At OptionsAnimal, we like to call it a “Protective Put” as it is “Protecting” our assets – our investments.

So, let’s say that you have 200 shares of AAPL. Very nice indeed. However, you are concerned that the stock market is about to take a bearish turn for a while. What should you do? You could simply sell the stock and move to cash. Many of us, however, would rather remain in the stock due to a longer term expectation that the stock will, over the long run, continue to move towards $350.00/sh. (OK, that’s MY personal expectation for AAPL by this time in 2011…). We are investors, not day traders. Here’s what I would do: Open your brokerage account and look for options on AAPL. Low and behold you are faced with many choices! You can select how much time you wish to purchase for this option and at what price you will be able to sell your stock for. A quick aside here: an option is a contract. A legal financial contract. Each option has both a buyer and a seller that when brought together (usually through an Exchange like the Chicago Board of Options Exchange – CBOE for short) create the contract. In the case of the Put option, the buyer is buying the RIGHT to sell the stock. Who buys it? Someone who sold that same option. The seller is entering into this contract knowing that they may have to buy your stock from you should you decide to EXERCISE your RIGHTS to sell the stock. Voi la – we have a contract. A party and a counter party. Very neat and tidy…

You have decided that with AAPL trading at $262.50 (or there about), that you will buy a strike 260 put option that expires in July. For this right you will pay (I’m guessing here because I’m in the “cheap seats” on a flight to Boston as I write this…) about $15.00 for this option. So, it works like this, if you add the cost of the option to your cost basis in the stock (and let’s assume that you bought AAPL before its most recent earnings), oh, for illustration sake, let’s presume that you paid 230/sh for your position, you have a cost basis of $245.00/sh. You now have the RIGHT to sell your AAPL shares by EXERCISING your option for $260.00/sh. That would be a net gain of 15.00/sh NO MATTER HOW LOW APPLE FALLS. AAPL falls to $200, you sell for 260. Steve Jobs is thrown in jail for something horrible and it turns out that AAPL has been “cooking the books” – APPL goes bankrupt, you STILL sell your stock for, yup, you guessed it, $260…

Here’s the part that is really different from the insurance analogy – if you decide that you no longer need the long put – you can sell it back to the market place! Try doing THAT with your insurance agent!

Anyway, there is obviously a lot more to it than that. There are times where it is proper to be carrying this sort of asset protection and times when it is not. There are ways to cut the cost of this insurance, and there are other strategies to protect your investments.

At OptionsAnimal, we place primary importance on protection of invested capital. The protective put is but on of the many strategies that we teach. It is part of one of our most popular trades – the Collar Trade. I’ll discuss that in more detail in another entry.

For now, understand that you do not have to go through periods of market bearishness or uncertainty without protection – you simply need to learn how and when to do it.

All the best and please invest wisely.

Jeff McAllister
OptionsANIMAL Instructor

Part 2 Trading Options by using “The Covered Call” strategy