Daily Gains Letter

How to Buy Insurance for Your Portfolio

By for Daily Gains Letter | Dec 19, 2012

DL_George_1The eurozone is in a financial mess and another recession that will likely extend into 2013. Spain will need to seek a bailout in spite of its denials. Italy is suffering. Greece needs to tighten up its belt and follow tough austerity measures just to survive.

Then you have the massive U.S. national debt in excess of $16.0 trillion that’s quickly approaching its legal limit of $16.4 trillion and will soon reach it unless the fiscal cliff is dealt with in some way.

Given all of these uncertainties, you should think about a viable investment strategy.

One investment strategy would be to take some profits off the table, but then you may miss out on a potential stock market rally.

At this juncture, stock markets are pausing and showing some uncertainty. And while I don’t pretend to have a crystal ball, I do firmly believe in having an investment strategy in place and adopting strong risk management to protect your investments.

The last thing you want is to watch your portfolio gains disappear.

My favorite investment strategy to protect gains is the use of put options as a defensive hedge against market weakness. This strategy is called a protective hedge.

Under this investment strategy, investors may be somewhat bearish or uncertain; and they may want to protect their current gains against additional downside moves in the stock or the market with the use of index put options on the DOW, S&P 500, or NASDAQ.

For those of you not familiar with options, a buyer of a put option contract buys the right, but not the obligation, to sell a specific number of the underlying instrument at the strike or exercise price for a specified length of time until the expiry date of the contract. After the expiry date, the particular option expires worthless and any responsibility is eliminated.

The buyer of the put option pays a premium to the writer of the option who gets compensated for assuming the risk of exercise. The writer of the put option is obligated to buy the stock from the holder of the put should it be exercised by the expiry date.

For the writer of the put option, the amount of premium received for assuming the risk is generally directly correlated to the volatility of the stock and the market. The more volatile the stock, the higher the premium paid for the option. And low volatility translates into lower premiums.

My investment strategy is to buy put options for stocks and/or sectors. If your portfolio is heavily weighted in technology, you can buy put options on the NASDAQ. You also can buy put options in PowerShares (NASDAQA/QQQ) exchange-traded funds (ETFs), a heavily traded put used for defensive purposes. Or let’s say you have benefited from the run-up in gold and silver but worry about the current weakness on the charts; an investment strategy would be to buy put options on The Philadelphia Gold & Silver Index (XAU), which tracks 10 major gold and silver stocks.

This put option investment strategy is straightforward. Just take a look at the various indices that closely reflect your holdings or put options on individual stocks that you may have a large position in.

In this market, safety is the key to a good investment strategy and having put options for insurance makes a whole lot of sense.

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