As we move along in 2012, we will likely see some decent gains, especially if the investment climate improves and market risk declines. Yet, if Europe worsens and the jobs and housing situation here fails to pick up, we could see market volatility and risk.
I’m a big believer in hedging against market weakness. A sound investment strategy is to take some profits off the table.
The key is to protect your profits by adopting a strong investment strategy and risk management to protect your hard-earned capital.
A favorite investment strategy I like personally for hedging is the use of put options as a defensive hedge.
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. By doing so, you are adopting a risk-managed investment strategy.
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 you are heavily in technology, a good investment strategy is buying puts on the NASDAQ. Or let’s say you have benefited from the run-up in gold and silver; an investment strategy may be to buy put options on The Philadelphia Gold & Silver Index, which tracks 10 major gold and silver stocks.
If your assets are heavily weighted in technology, an investment strategy may be to buy put options in PowerShares (NASDAQ/QQQ) ETFs, a heavily traded put used for defensive purposes.
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 and buy the appropriate hedge.
The current market risk is high due to the debt and growth problems in Europe and the U.S., which you can read about in European Union: Resolution Up in the Air Means Continued Risk.