We saw a nice stock market bounce on Wednesday after the announcement of a concerted effort by numerous central banks around the world to help alleviate the stress of the European debt crisis. The gains are welcomed and will give you an opportunity to take some profits or cut some of your losses as we approach the year-end.
The reality is that you 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 optimism amongst the bulls, but I do not believe stocks can continue to rally much higher given the upper resistance and risk.
What I suggest you do is shield your profits by adopting strong risk management to protect your investment portfolio. 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, you 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.
I continue to recommend using put options or buying short-based exchange-traded funds (ETFs) as an offset to the weakness. It’s easy and cost-effective as a hedge for your investment portfolio.
Just take a look at the various indices that closely reflect your investment portfolio or put options on individual stocks that you have a large position in. Index puts include the SPY (S&P 500), QQQ (NASDAQ), or IWM (Russell 2000).
You can play an aggressive downward slide in technology via the Direxion Technology Bear 3X (TYP).
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.
In this market, I still believe the risk is high. Safety is the key—your investment portfolio will benefit from you taking this stance.
A debt plan may be in place for Europe, but don’t forget about the debt and deficit problems at home that you can read about in America, Time to Talk About Our Debt.
Interested in learning about some of my favorite small mining stocks? Read Mining for Riches: Great Metals Stocks to Check Out.