How to Protect Your Portfolio From Market Weakness

portfolio protectionThe sell-off we saw on Tuesday could be the beginning of additional losses and a meaningful correction. What I’m seeing is a weakening of the technical picture.

As at the close of Tuesday, the DOW has corrected 4.19% from its recent two-year high, while the Russell 2000 is down 3.49% and the NASDAQ is down 4.75%.

I’m also continuing to see a decline in momentum. The new high on the NYSE hit a mere 29 on Tuesday. The new-high/new-low ratios on the NYSE and NASDAQ fell to neutral, which was the first reading below bullish since August 25 and September 3, respectively.

The near-term technical picture has weakened to neutral from moderately bullish and is showing fragility, with the Relative Strength weakening at below neutral, which indicates some further weakness in the near term.

I have been warning of a potential correction and have emphasized the use of put options as a hedge against the kind of weakness we are currently witnessing.

While I’m not sure if this is a correction in the making, I am concerned about the failure to rebound back to the recent highs.

So, given this, I will once again introduce the concept of put options as a defensive hedge against market weakness. This strategy is called a “protective hedge.” Don’t be scared by the name or the fact it employs derivatives, as the strategy is straightforward.

Under this scenario, investors may be somewhat bearish or uncertain and want to protect their current gains against a downside move in the stock or the market with the use of index put options.

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 portfolio is heavily in technology, you can buy puts on the NASDAQ. Or let’s say you have benefited from the run-up in gold and silver to record historical highs, a strategy may be to buy put options on The Philadelphia Gold & Silver Index, which tracks 10 major gold and silver stocks.

If you are heavily weighted in technology, you can buy put options in PowerShares ETFs (NASDAQ/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.