Listen up folks, stock markets have had a great run advancing in five straight weeks and breaking away from or near to bear market status. There may be more upside moves ahead of us should the economy continue to improve, but you also need to be careful.
You have probably made some nice profits on your investment portfolio, so my advice to you is to take some profits off the table. I’m seeing some incredible euphoria amongst the bulls, but I do not believe stocks can continue to rally without some sort of market adjustment. I have discussed this belief numerous times in past commentaries.
If the economy doesn’t deliver jobs this week, your investment portfolio could retrench. The key now is to protect your profits by adopting strong risk management to protect your hard-earned capital. The last thing you want is to watch your gains disappear.
One of my favorite strategies I like personally to protect an investment portfolio is the use of put options as a defensive hedge.
Under this scenario, investors may be somewhat bearish or uncertain and want to protect the current gains against a downside move in the stock or the market with the use of index put options. By doing so, you are hedging your investment portfolio.
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 market. The more volatile the stock, the higher the premium paid for the option. And low volatility translates into lower premiums.
You can buy puts for stocks and sectors. If your investment portfolio is heavy in technology, you can buy puts on the NASDAQ. Or let’s say your investment portfolio has benefited from the run-up in gold and silver to record historical highs; a good strategy may be to buy put options on The Philadelphia Gold & Silver Index, which tracks 10 major gold and silver stocks.
If your investment portfolio is heavily weighted in technology, you can buy put options in PowerShares ETFs (NASDAQA/QQQQ), a heavily traded put used for defensive purposes.
It’s that easy. 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 and your investment portfolio will benefit from it.
An area that I continue to like given the strength of metals is that of mining stocks. You can read about it in Why You Might Want to Look at Buying the Miners, where I list three examples of interesting mining stocks.