The future of the world economy is very uncertain. European sovereign debt is scaring many investors and policy makers. Unemployment, although improving in the short-term, is still a major problem. Housing prices continue to languish.
It seems the only certainty in today’s market is volatility. Some might even go to the extreme of saying that there is a coming economic maelstrom that is going to wreak havoc on the financial system and do major damage to the unprepared. The great news…there is a form of insurance that can be used to protect the value of your investment in equities.
Insurance is a math game for most insurance companies. As a definition, insurance is a form of risk management primarily used to hedge against the risk of a contingent uncertain loss. Depending on what type of insurance you are purchasing, the insurance company defines risk based on a factors that may cause a potential “claim” against your policy against loss. Life insurance companies, as an example, will look at your age, overall health, family history, as well as lifestyle to consider how much “premium” to charge for you policy. This math game is no different in the stock market.
One great advantage about options as insurance, instead of normal insurance is the ability to use timing. In the market you can buy insurance for a specific amount of time and then resell that insurance when you do not feel it is needed anymore and capture any remaining premium. You certainly couldn’t ask your insurance company for insurance just for next week because you might be in an accident and if you are not in one, then ask for your money back. The likely outcome would surely involve laughter and a finger-pointing to the door. This application is called a Protective Put, or in some case as “Married Put” and is done every day in the markets. Let’s look at an example.
By definition, a married put is an option strategy whereby an investor, holding a stock position, purchases a put position on that same stock to hedge against a decline in the value of the stock. Let’s say you purchased shares in XYZ corp. at $50/share. The company has their quarterly earnings report in a few days, so as a form of insurance, you buy a $50 Protective Put. This allows you to sell the stock at $50, regardless of the price of the stock. If the company were to come out with bad news and the company’s stock price dropped in value to, let’s say $30/share, that protective put gives you the right to sell your stock at a fixed price within a set time frame ($50). You have the right exercise your put option and get rid of your stock. This certainly beats the old buy and hold strategy with a stop-loss for protection.
This strategy can be employed in front of uncertain events, like earnings or new product announcements. It can also be implemented in times of overall economic uncertainty. This simple tool saved millions of dollars when the financial system melted down in 2008. Think back to 2008 and what happened to your portfolio during that time frame. How great would it be to have your money back from prior to that bubble bursting? Many investors, when they first start trading have the occasional sleepless night and heartburn because of worry over stock prices . Will it drop, a lot? Will I have any money left? What would I do next? There is a constant worry of where the market might open and the feeling of having to be stuck in front of the television or computer to monitor positions. This strategy will ease those fears.
This same strategy can be used when you have technical sell signals in your trades. This could be bullish or stagnant types of trades you may have placed. If you were to apply this strategy (protective put) and the stock then trended lower, the protective put would gain value while your other trade was losing value. The flexibility of this instrument allows for protection of any trade, as well as the ability to time the addition of that protection to your position. For example, employing a protective put, while the stock was trending lower, protected your initial trade. The next step would be identifying when the stock has given signs of a bottom, selling to close your protective put and capture any profits. This would lower your cost basis in your original bullish trade. As the stock the heads back up, it allows you to potentially make money on your original trade and lower the level that it must increase to in order to make a profit. This type of timing allows you to not “panic” out of positions, only to watch them head back to where you thought they were going to begin with.
The next logical thought might lead you to the idea that you can be very flexible with this investing tool and take a bearish position if you wanted. This would allow you to not only insure your positions that you have, but potentially speculate that the coming economic storm would cause damage to other stocks you don’t own. The opportunity is vast when it comes to the application of this trade. One thing is for sure; it allows an investor to sleep at night in the midst of all of this chaos.
OptionsANIMAL Founder and CEO