Don’t Be a Hero; Be Smart and Protect Your Capital

Be Smart and Protect Your CapitalThe eurozone is in a mess and headed toward a recession next year. Spain may need to seek a bailout. Italy is not there yet, but it’s suffering. Greece needs to tighten up its belt and follow tough austerity measures or risk possible default. China is facing slower growth and is set to change its leadership at this critical time. And then there’s the upcoming U.S. fiscal cliff. (Read “Why the Election will Dictate Which Way America Goes.”)

With all of these global economic factors, you need to think about a viable investment strategy.

The charts are bearish being below the 50- and 200-day moving averages (MAs) and void of any momentum, based on my technical analysis.

An investment strategy would be to take some profits off the table, but then you may miss out on a potential stock market 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 of mine 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 their 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 is worthless and any responsibility is eliminated.

The buyer of the put option pays a premium to the writer of the option, who is 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 option 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 put options for stocks and/or sectors. If your portfolio is heavily in technology, you can buy put options on the NASDAQ. Or let’s say you have benefited from the run-up in gold and silver but worry about the current weakness and death cross on the charts, an investment strategy would be to buy put options on The Philadelphia Gold and Silver Index, which tracks 10 major gold and silver stocks.

If your portfolio is heavily weighted in technology, you can buy put options in Invesco PowerShares Capital Management LLC (NASDAQA/QQQ), a heavily traded put used for defensive purposes.

This put option investment strategy is straightforward. Just take a look at the various indexes 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 to a good investment strategy.