The Best Way to Hedge Your Portfolio

With markets challenging all-time highs, continued geopolitical drama unfolding, and many influential investors calling for a market correction in October 2017, it was never a bad time to consider hedging your risk. Especially in a bi-polar market…

Between September 1929 and June 1932, the S&P 500 fell 86%.

From May 1946 to June 1949, the index fell 29.6%.

From December 1961 to June 1962, it fell 28%.  It fell another 36% between 1968 and 1970, and another 48% between 1973 and 1974, another 27.8% between 1980 and 1982, another 33.5% in 1987, and 49% between 2000 and 2002.

We could go on and on. But the point we’re trying to make is that crashes happen.

In fact, according to many experts, another one may be nearing.

Those that prepare in advance for them stand to do okay. Those that choose to do nothing have seen fortunes wiped out in no time at all.

If you’d rather not see your money get flushed in a market correction, here are two simple ways to protect your portfolio today.

Gold is always a safe haven to run to, but another way is to hedge with put options.

While it’s possible to hedge your portfolio by buying put options on each of the stocks you own, that’s not always a good idea.  First, not all stocks have options available, unfortunately. Also, even if options are available, they may not be liquid enough.

The safer way then is to choose an ETF that may be a good match for stocks in your portfolio.  For example, if you have mostly semiconductor stocks in your portfolio, one way to hedge your portfolio is by buying a put option on the Van Eck Vector Semiconductors ETF (SMH). That way should your portfolio of semiconductor stocks begin to dive, you at least have some protection on the short side. It’s better than having no protection at all.

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Or, let’s say you have a portfolio of large cap stocks. You may want to consider buying a protective put option on the SPDR Dow Jones Industrials ETF (DIA).  The last thing you want to do is to get caught with your pants down, with no protection. 

However, if you’d also like to protect against stock downside, too, you can.

The primary benefit of a protective put is to protect you against losses during a price decline, while still allowing for stock price appreciation if the stock increases in value. If the stock goes up, you have unlimited profit potential, and if the stock goes down, the put goes up in value to offset losses on the stock.

For example, in early September 2017, shares of Apple (AAPL) traded at $164 a share. Over the next few weeks, the stock fell from $164 to $150 a share, wiping out a good chunk of value. But let’s say you picked up a protective AAPL November 2017 165 put at the time to protect from the potential for downside from those highs.

You could have picked up those put options at $7.50 (or $750 per contract) on September 1, 2017. Then, as the stock began to pullback to a low of $150 a share, those puts ran as high as $16.75. So, even as the stock fell 9%, the put boosted your portfolio with a win of 123% on the protective put.

Look, we all take risks by trading the market, but smart traders know how to control their risk and use it to their advantage. Either protect yourself, or expose yourself to undue risk.

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