Things You'll Need:
- Investment account
- Options trading
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Step 1
Buy put options. Put options gives you the right to sell at the agreed upon price at a later date. So if the market falls, you can sell your options or stock for a profit and offset your loss. Simply put, this is your insurance against loss. The rationale is very simple. You wouldn’t risk not taking car or home insurance policy, why should your investment be any different?
- Put option can be against the individual stock that you own or against an index which your portfolio models after or a major index, such as S&P 500, for general down side protection.
- So depending on the worth of your portfolio and the premium you are willing to pay for put options, you should calculate the number of put contracts you need to buy. Note that each put contract gives you the right to sell 100 underlying security, so your total cost is (option premium * 100) + commission.
- Let's say you bought 100 SPY for $90 each. To protect this $9000 investment, you would buy a put contract for selling SPY at $90, say 3 months into the future. If the contact costs $5 and commission is $8, your total put cost would be (5*100) + 8 == 508. So your total investment cost would be $9508. In other words, you would have paid 5.64% premium (i.e. 508/9000). So if your investment rises above $9508, you make a profit. On the other hand, if it falls below $8492 (i.e. 9000 - 508), you would claim your insurance policy. -
Step 2
Shorting stocks. This is opposite to buying stocks. The idea is that you would be borrowing the stock and selling the right to acquire it at a future date for today’s price. You are betting that the stock would fall such that you can buy at a cheaper rate in the future and repay your obligation while pocketing the proceeds from short sale. In a bear market, this is a great way to hedge your loss or make money. That said, keep in mind that speculation is dangerous.
- To illustrate, suppose you believe that SPY is over-valued at $90 and expect it to take a beating in the near future. To sell short, you would borrow 100 SPY and sell a contract to buy at $90/share, say 3 months into the future. If the contract sells for $5, your proceeds would be $500 (ignoring commissions). So if SPY falls below $85, you stand to pocket $500. If SPY rises above $95, you stand to lose on your bet.
- While the profit potential is limited, the loss potential is unlimited. I.e. in the example above, there is no telling by how much SPY would rise, so your risk is unlimited. -
Step 3
Flight to quality. Cash and bond can act as hedge against market fluctuation.
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Step 4
Real assets. Real estates/REITs and commodities can offer excellent hedge and diversification. For commodities, you can either trade commodity futures or invest in commodity ETFs. That said, commodities tend to correlate closely with the performance of broader economy, so you need to be careful when using it for diversification.
