Protect Your Portfolio With This Strategy
To put it mildly, 2020 has been an unusual year. For investors, the market fell and then rebounded so quickly that it felt like it could cause whiplash. In fact, the S&P 500 had its fastest drop into bear territory and the fastest recovery in history.
The above chart shows just how much of a roller coaster this year has been. From the February 19 (then) all-time high to the March 23 bottom, it took the S&P 500 only 23 trading days to lose 34%. And then from March 23, it took just 103 trading days to recover all lost ground and set a new closing high on August 18.
If we look back further at another steep drop in recent years, we see that during the Great Recession and Financial Crisis more than 10 years ago, it took the S&P 500 355 trading days to fall from its then record high to its March 2009 low. From there, it took 1,021 trading sessions (more than four years) for the S&P 500 to climb back to its previous closing high:
You may have already noticed that in both cases it took the market far longer to come back than it did to drop. Indeed, on Wall Street there’s a saying that stocks fall three times faster than they rise. During normal times, that’s not necessarily true. But when extreme volatility hits the market, stocks do tend to fall a lot faster than they rise. This makes sense because for most people, the fear of losing what they already have is greater than the desire to gain what they don’t yet have.
Protecting Your Portfolio
Seeing how quickly things can get ugly, it behooves investors to have some protection in place to guard against sudden steep drops. One strategy to consider is to buy puts against stocks you have.
For example, let’s say a month ago you bought 200 shares of General Electric (NYSE: GE) for under $8 per share. You have a nice gain on it. You want to keep the stock but you are worried that the aviation and power divisions are vulnerable to bad news given the uncertainty surrounding COVID-19. You don’t want to lose your profits, so you buy two GE January 15, 2021 $9 puts for $0.18.
If GE doesn’t drop under $9 and you hold the option to expiration, you lose the whole $36 ($0.18 x 2 x 100), but if it does fall below $9, you can exercise the option and put the stock to the counterparty at $9 no matter how low GE falls.
Benefits of a Put Option
Unlike a stop-loss order, when you buy a protective put, you guarantee you will sell at the strike price. Note that when you use a stop-loss order, there’s a risk that you could end up getting a lower price than you intended because the sell-stop order becomes a market order when it’s triggered. And if you use a sell stop-limit order, your sell order may not fill. (If you are unclear about the different type of trade orders, see my previous article that discusses the topic.)
A put gives you peace of mind. Since you know you will be able to get $9 for GE, you won’t get nervous and panic sell no matter how scary things look. Imagine the seller’s remorse of people who sold into the crash and got back in too late.
With a put option, for $36 ($0.18 x 2 x 100) plus commission (which should be negligible), you guarantee that you will be able to sell GE for $9 by January 15, 2021 no matter how low it falls. And of course, depending how prices move and how your opinion on GE changes, you can always close the option before expiration and sell GE as well. The put merely offers a layer of protection. It does not take away your flexibility.
Editor’s Note: Our colleague Scott Chan just explained a time-proven hedging strategy, but maybe options trading isn’t for you. Here’s a “safe haven” asset class that belongs in every portfolio: gold. The yellow metal is another way to gain portfolio protection.
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