It happened in 1987, it happened again in 1999, and once again in 2007. Make no mistake, it will happen again. Billions of dollars were lost by unsuspecting investors during very short periods of time.
All good things must come to an end. That includes this roaring bull market in stocks. There is no question that there is a definitive upward bias in the stock market. Looking at any long term chart makes this abundantly clear. Market experts and statisticians call this bias an upward drift in prices.
However, despite this upward drift, there are very distinct periods of time that the stock market sells off in a dramatic way. Savvy traders and investors use these periods of selling to buy stocks at a discount. Unfortunately, many long term investors suffer major losses during these selloff periods because they are not prepared for these inevitable market declines.
The inherent issue is that no one knows for sure when the sharp sell offs or even stock market crashes will occur. This means that the wisest course of action is, after you reach a pre-determined level of profits in your portfolio from the bull market move, to take action to protect your profits.
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I am certainly not advocating selling to lock in your gains. While this certainly works, it eliminates the potential for additional upside gains.
What’s the solution?
How can you protect your profits while at the same time allow the bull market to continue to work its profit magic?
Wouldn’t it be great if there was an insurance policy that could be purchased to protect your stock market portfolio?
Just like auto or home insurance. You would pay a small premium and are protected financially in case of a car crash or costly damage to your home and belongings. Insurance allows you to protect your assets while still enjoying them. Better yet, it only costs a small fraction of what it would cost to replace the asset. It makes tons of sense to have an insurance policy on your costly things. The same can be said for your investment portfolio.
Believe it or not, there is insurance available to protect your portfolio from market panics, plunges and crashes.
While you are not able to purchase this insurance from a traditional insurance broker, your stock trading brokerage will be able to provide it to you. All you need to do is make certain that your investment account is approved for option trading to be able to access this insurance.
Here are 3 ways to protect your profits.
1. Purchase Put Options
This is the easiest way to protect your portfolio. Each put option represents 100 shares of stock. This means for every 100 shares of a stock in your portfolio, purchase one put option to protect from downside risk. You see, a put option increases in value as a stock drops in price. This rise in the option price, in effect, counteracts the drop in each 100 shares of stock.
I like buying puts for insurance that are at the money. This means that the strike price is below or equal to the trading price of the stock. In addition, I prefer to buy put options with 3-4 months of time premium left at the time of purchase. There are investors who purchase puts on a monthly basis to protect against downside risk. These puts are cheaper due to less time premium, but there are the transaction costs to keep purchasing month to month. Not to mention, I like to keep things as simple as possible, so every several months makes sense for me.
2. Use Collars
Unlike a buying puts directly, collars are an option strategy that can actually have little or no cost for the investor. Allow me to explain.
A collar is the simultaneous purchase of a put option and the selling of a call option. Both options are out of the money and generally have the same expiration date. For every 100 shares of stocks that you want to protect from downside, one put is purchased and one call is sold at the same time. For example, if you own 1000 shares of XYZ, a collar would consist of buying ten put options and selling 10 call options to protect all 1000 shares. The options are dated for how long you are seeking downside protection. If you believe things will stabilize in 5 months, the options chosen for the collar would be 5 or more months until expiration. Stated simply, the premium received for the call options is what is used to offset the purchase price of the protective put options.
At certain times, you are able to establish the collar at no cost due to the call premium received, the collar is known as a zero-cost collar.
You own 100 shares of ABC stock that is now trading at $35.00. Some bad news has knocked the stock off its highs of $37.00 and you are afraid it could easily go lower over the next several months. In order to keep holding the stock, you decide to use an option collar for downside protection. This means buying one put option five months from expiration at the $32.00 strike price for $2.00 per option or $200.00 total. Simultaneously, you sell one call option, five months from expiration with a $38.00 strike price at $2.00 per option or $200.00 total. This creates a 5 month zero cost collar to protect your stock investment from downside risk.
4. Buy Crisis Proof Investments
Diversifying into assets that are generally considered stock market crisis proof is another way to protect your portfolio. Crisis proof assets usually include precious metals such as gold and silver, currencies, and more esoteric assets like art and other collectibles.\
Generally, a well diversified portfolio consists of 10 to 15% of these types of crisis proof assets.
The Key Takeaway
Be prepared for the inevitable declines in the stock market. Diversifying via crisis assets and utilizing options as an insurance policy make solid sense for investors .