Listen up folks; stock markets have had a great run, and there may be more upside moves ahead of us, as the economy continues to improve, but this is not a time to be aggressive. You have made some nice gains and, with year-end approaching, 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 that stocks can continue to rally without some sort of market adjustment. I have discussed this belief numerous times in past commentaries, so I hope you have done so.
Technology bellwether Cisco Systems Inc. (NASDAQ/CSCO) lowered the boom on traders when it reported a mixed report after the close on Wednesday. The tech leader did manage to beat slightly on revenues and earnings per share in its fiscal first quarter, but what is scaring off traders is a contraction in gross margins and a weak revenue forecast. The results appear to be more company-specific, but nonetheless it may also indicate some fragility.
We are continuing to see a decline in momentum. The new highs on the NYSE fell to 170 on Wednesday, representing a major decline from 398 on Tuesday and 360 new highs on Monday. The reality is just last week that there were 603 new highs on Friday and a whopping 679 on Thursday. This decline in new highs is a red flag if it continues to weaken.
At this juncture, stock markets are pausing and showing a downward negative bias. And while I do not pretend to have a crystal ball, I do firmly believe in adopting strong risk management to protect your investments and hard-earned capital. The last thing you want is to watch your gains disappear.
One of my favorite strategies I like personally to protect investment gains is the use 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 that it employs derivatives, as the strategy is straightforward.
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.
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 heavy 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 for you 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 (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.