How to Buy “Insurance” for Your Investments

— “Calling the Trend” Column, by George Leong, B. Comm

We are seeing some fragility in the stock markets, with the major indices down in five of the last seven sessions. The DOW recorded its second straight 100-point loss yesterday, while the S&P 500 is below a key level at 1,080. Trading volume on the NASDAQ was above the five-day moving average over the last two days of selling, which is bearish. Market breadth has been negative in eight of the last 11 sessions. The near-term technical picture has turned neutral to moderately bearish on weakening Relative Strength, so we could see further downside moves. The overall market risk has risen, so watch your positions.

Traders are nervous after the release of a weaker-than-expected Consumer Confidence report on Tuesday, which likely reflects the continued concerns towards jobs and housing. The Case Shiller Home Price Index rose in August from July, but fell year-over-year. There are signs of improvement in housing, but we are a long way from price increases.

United States Steel Corporation (NYSE/X) reported a third straight quarter of losses, as demand continues to be soft. This reflects the continued struggle of the global economies. Watch for Visa, Inc.  (NYSE/V) to report shortly, as a barometer on global spending.

At this point, be prudent. If you are familiar with options, you may look to write some covered calls on some of your long positions to generate some premium income and reduce your average cost base. This strategy makes sense if you feel the upside is limited.

Another alternative could be to establish a Put Hedge through buying put options on stocks or against an index that reflects your holdings. For instance, heavily weighted technology holdings could be hedged by buying puts on the NASDAQ. Remember that index options are cash settled.

With Put options, investors are bearish and are betting on a downside move in the stock or the market. Put options are also used as a method by the writer of a put option to set a lower price at which to buy the stock.

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.

Let’s say you believe technology is overvalued due to the run-up this year of the NASDAQ. Under this scenario, you could buy put options on the NASDAQ. Should the NASDAQ pull back, the value of your put options would rise and help to offset of the decline in your holdings.

It’s unlikely you would drive without insurance or not have your home or valuable assets insured, so why would you not protect your investments? Think of put options as buying insurance coverage on your investments.