Stock Market – Fragile Conditions Mean You’d Better Have Protection

investment strategySpain may need to seek a bailout. Italy is not there yet, but the high yields will hurt and are unsustainable for these eurozone countries struggling with high sovereign debt and muted growth. China is facing slower growth and is planning to pump money into the economy. You need to think about a viable investment strategy.

The charts are bearish at below the 50-day moving average (MA) and void of any momentum. And, while it looks like the key stock indices will hold above the 200-day MA, you never know. For instance, if Spain goes belly up, the impact would be felt in Europe and globally.

An investment strategy would be to take some profits off the table, but then you may miss out on a potential stock rally.

At this juncture, stock markets are pausing and showing some uncertainty. And, while I do not pretend to have a crystal ball, I do firmly believe in having an investment strategy in place and adopting strong risk management to protect your investments.

The last thing you want is to watch your gains disappear.

A favorite investment strategy to protect gains is the use of put options as a defensive hedge against market weakness. This strategy is called a “protective hedge.”

Under this investment strategy, investors may be somewhat bearish or uncertain and want to protect the current gains against additional downside moves 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.

My investment strategy is to buy puts for stocks and/or 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, but that you worry about the current weakness and death cross on the charts; in this case, an investment strategy would 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 (NASDAQ/QQQ) exchange-traded funds (ETFs), a heavily traded put used for defensive purposes.

This put option investment strategy is straightforward. 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.

One stock I would avoid at this time is over-hyped social networking play Facebook, which I discussed in Facebook Faces Valuation Issues.