The market appears to have another bull leg with the DOW and S&P 500 closing higher in seven of the last nine sessions to March 6. The blue chip stocks have been especially strong, with the DOW hitting a record close of 14,296.24 and intraday at 14,320 last Wednesday. The S&P 500 is also approaching its historical high.
With the advance, there are now questions regarding the sustainability, which you can read about in “Why Near-Term Prospects in the Stock Market May Be Limited.”
While the global economy is improving, the catalyst for the upward move in stocks has largely been the easy monetary policy worldwide that has resulted in a low-interest-rate environment and the search for alternative investments other than low-yield bonds.
So while all is fine now, I still sense a correction could be in the works, especially if the S&P 500 stalls.
You need to think about a viable investment strategy as a defensive posture. I firmly believe in having an investment strategy in place and adopting strong risk management to protect your investments.
One investment strategy would be to take some profits off the table, but then you may miss out on a potential stock rally.
A popular 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 heavily weighted 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 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, another investment strategy is to buy put options in the PowerShares QQQ (NASDAQA/QQQ) exchange-traded fund, a heavily traded put used for defensive purposes.
For the Dow Industrial, you can buy puts on the SPDR Dow Jones Industrial Average (NYSE/DIA).
For the S&P 500, there’s the SPDR S&P 500 (NYSE/SPY).
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 to a good investment strategy.