2 Easy Ways to Protect Your Portfolio
You have enough to worry about in life without adding in day to day market volatility risks.
You protect your most valuable assets, life, home, and auto with insurance. It’s a smart investment. The cost of the insurance can give you peace of mind knowing you are covered in case of any unfortunate events.
But few traders hedge against the risks in the stock market, leaving exposure to large swings in equity prices.
The most common price protection comes in the form of insurance.
Think about your house for a minute. What if you didn’t insure it and it ends up burning to the ground? Now imagine paying for puts that expire worthless. Pretty upsetting isn’t it? If you want to insure your options, buying a put can put in a price floor for your stock. Think of it as paying for an insurance premium where you end up paying just a deductible in the event of a loss.
A balance between that protection cost and financial exposure make for better night’s sleep.
One way that some investors get no cost protection is through a collar strategy.
What is a Collar Strategy?
A collar pays for the puts by selling covered calls.
The no-net cost protection is financed by selling out-of-the money calls. It caps profits to the limit of the strike sold but eliminates out-of-pocket costs.
The sacrifice of limited upside is a tradeoff for a price floor. Sell calls to pay for put protection.
Now you’re ready to start insuring your portfolio. Here’s how it’s done…
Limit Your Losses
Much like other forms of insurance, the first step is to determine how much protection you need. After that, it’s all about determining the deductible.
It goes without saying that the more responsible you want to be to cover losses, the lower the cost it will be. Decide if you want to limit losses to 5%, 10% or a more catastrophic 20% or more.
Once you’ve figured that out, buy puts to place absolute portfolio price floor.
Pick a Timeframe
The timeframe is a method of rolling out expirations that can also help reduce the cost. Time decay starts 90 days before expiration, with sharper acceleration in value losses inside of one month.
To alleviate a large degree of the melting, buy nine-month options and exit them when they have three months to go. An immediate roll into new nine-month option maintains protection and is repeated twice a year.
For example, if a nine-month SPY put is purchased at $10 ($1000) it is worth about five dollars ($500) six months later if the market is the same price. The actual time decay and cost for the six months of protection was $500.
That six months of protection maintained an unlimited upside with a cost of just over 2% of the $21,000 value.
As with any insurance, the premium paid is for protection – that assurance that the asset value will be there is a small cost to pay. And as always, do your own calculations and do your due diligence before making any decisions.
Keep it In the Money,
Trading Tip of the Day: Keep it Simple
The best way to book consistent gains in the market is to keep it simple. That’s how I approach the search for all my longer-term trades.
The very first thing you want in a long-term trade is performance. We want to capture the meat of a big move higher. That means we want stability and a solid uptrend.
Let’s say you’ve read about a stock on a financial news site and you’re bullish on its prospects. Take 30 seconds and pull up a simple long-term chart going back at least two years. If the stock is moving “bottom left to top right,” you’re on the right track. No fancy technical analysis required.
Once you’ve found a play you like that’s locked in a strong uptrend, you’re ready to put it on watch. Step two in our trading process is learning when to pull the trigger. After all, buying is the most important part of this whole process.
Don’t blindly throw money at a play just because it’s trending higher. Instead, you should wait for the for a bounce near a key support level (along a trendline or moving average) before pulling the trigger.
— Greg Guenthner