Why does every investor feel bad when the news announcer tells us that the S&P 500 fell 1% today?
Why do investors assume that their portfolio lost 1%? The reason is, most mutual funds and stocks do the same thing the S&P 500 does. When the market falls, so does the value of most portfolios.
What is a protected portfolio? Also know as a hedged portfolio? The way to protect a portfolio from a stock market crash or correction is with a put option.
A put option is used in two ways:
- Investors or traders will buy a put option because they think the price of a stock will go down, and they would like to profit from the fall.
- Put options can protect a stock investment like an insurance policy for the portfolio. It give the owner the option to sell the stock at the strike price.
The way an investor hedges an entire portfolio works like this. The S&P 500 or easier to use is ticker $SPY is trading at $178. The December 2014 put option for the $160 strike price is $6.00. This means that if the SPY falls below $160 by December 2014, the owner of the put option can sell shares of $SPY for $160, even though the price may be at $140.
The reason no one likes this method. The cost to protect the portfolio is 3.3% and that only offers protection of a loss greater than 10%. So all the put option does for the investor is protect in the event that the markets fall 13% in 2014.
Another way to profit from the fall of the stock market is to trade options. Trading options consists of buying put options in anticipation of the market moving lower. When the market moves lower, the price of the put option usually will go up.
Read our article about trading a covered call.