A Smart Way to Hedge Your Investments (With Options)

For the last month or so, the European debt crisis has crushed the U.S. stock market.  Will fears of a global melt-down continue to depress our markets, or will we enjoy a Santa Claus rally next month?

The answer is that no one really knows.  We can all wager a bet as to which way the market will go, but it really is no more than a guess.  We all know the market moves both ways, but we never know which way it will move next.

I believe that some of everyone’s investment portfolio should be in a hedge that protects against the market moving down.  Most people are quite eager to buy stocks or mutual funds, but very few set up a hedge in case they are wrong.  Today I would like to discuss exactly how that hedge might be set up.

A Smart Way to Hedge Your Investments (With Options)

Let’s say you have accumulated a nest egg of $25,000 which you have wisely placed most of it in an index fund (I say wise because index funds, over time, consistently outperform every other kind of mutual fund investment).

Now let’s assume that you are super-smart, and have decided to take $5000 (20% of your total investment portfolio) and placed it in an investment which will prosper if the market should fall.  In my opinion, that hedge should be an options portfolio much like an actual portfolio we carry out for Terry’s Tips subscribers.  We call it the 10K Bear.

Four weeks ago, the market (the S&P 500 tracking stock, SPY) was at $128.60.  Last Friday, SPY closed at $116.34, a drop of $12.26, or 9.5%.  Presumably, your index fund lost exactly that amount.  On your $20,000 investment, you have lost $1900 over those 4 weeks.

Now let’s check out how well your 10K Bear portfolio has held up.  Our actual portfolio (which many subscribers mirror on their own or have thinkorswim make the trades for them through their Auto-Trade program) gained 80% after commissions.  If you had invested $5000 (20% of your total investment portfolio) in the 10K Bear, you would have gained $4000 over those 4 weeks while the market tanked.

Bottom line, if you had invested 20% of your money in the 10K Bear and 80% of your money in an index fund, you would have a net gain of over 20% for the period rather than a loss of 9.5%.  In fact, if you had only put 10% of your funds in our bearish options portfolio, you would have broken even for the period rather than losing 9.5%.

Here is how the 10K Bear should perform this week (ending Friday, December 2).  The portfolio is currently worth $6730 but we will withdraw money again next week so that subscribers can mirror the portfolio with close to $5000:

The P/L Day column in the lower right-hand corner shows the expected gain if the stock closes as the Stk Price (left-hand corner column).  You can see that an average gain of about 13% will come if the stock stays flat or falls by as much as $3.  It can go $2 higher and a profit will still be made.  Only if the stock goes up by more than $2 ½ should a loss result (assuming no adjustments are made).

If the stock fluctuates more than $2 in either direction early in the week, we would probably make an adjustment which would shift the above curve in the direction that the stock has moved.  This adjustment would usually reduce the maximum possible gain for the week but would increase the chances that a good gain would result.  Above all, we do our best to avoid a loss of any amount.

How is this portfolio set up?  It consists of owning SPY puts which expire in January or February 2012 and selling Weekly puts (at lower strike prices) that expire this Friday, December 2nd.   If the stock holds steady, the decay rate of our Weekly puts is greater than our longer-term long puts, and the portfolio gains from the difference in decay rates.

If the stock falls, since the long puts are at higher strike prices, they increase in value at a greater rate than the short puts do, and even larger gains are possible.  If the stock falls too much, at some point the long and short put positions go up at essentially the same rate (and we would make an adjustment by rolling down some of our short puts to even lower strikes).

This may seem a little complicated to you right now, but it is a very simple strategy once you watch it unfold in the real world for a few weeks.  Many subscribers mirror our portfolio on their own until they have confidence that they understand it sufficiently to carry it out on their own (and we are delighted to have an ex-subscriber who is making big bucks and will say nice things about us).  

For an investment of only $79.95 (subscribe here), you can learn all the details of a hedge that could have turned the losses you incurred over the last month into gains which were twice as great as those losses. (This price includes weekly updates on the 10K Bear and 7 other portfolios for two months.)  Of course, that investment gets you a whole lot more than the details on this bearish hedge.  But even if there were nothing else, it is a huge bargain that you should be able to use for the rest of your life to increase your annual gains year after year (especially in those times when the market falls, as it will).