Recent economic turmoil in the United States has left many families worried about their investment portfolios and retirement accounts. Whatever to classify current conditions as a recession is another matter, but most would agree that markets face an uncertain future amid unpredictable events.
Further compounding this problem is the fact that markets do not move the same way they used to, even in the long run. No longer are solid financials necessary to ensure the prosperity of a company. Should a disastrous event take place halfway across the world – such as a tsunami or a terrorist attack – shares of public companies will exhibit adverse reactions, even if the stocks are remotely related to the events taking place. The question is … How do you protect your portfolio from a recession and / or unharmed events?
Many people have heard of stock options but never knew what they were. Some companies offer options to their employees in lieu of some salaried compensation. The truth is that options for public companies are available to all investors so long as the stock in question has associated options. There are about 3,000 to 4,000 optionable stocks on US markets.
It is true that money can be made by trading options during bull or bear markets, but that is a subject for another article. For now, let's discuss the put option as a means of insuring investments. By definition, an options contract gives its holder the right, but not the obligation, to exercise a stock at a specific price within a set period of time. What exactly does this mean?
Let's say you have shares of ABCD currently valued at $ 100 per share. Now let's say a 120-day put option for ABCD has a strike price of $ 100. And let's say each option costs $ 4 each. The option will give you the right (but again, not the obligation) to sell ABCD for $ 100 dollars anytime within the next 120 days. If ABCD drops precipitously within the next 120 days – say, to $ 50 per share – then this is a good deal. Instead of taking a huge loss by selling at $ 50, you could sell at $ 100 regardless of the current market value of the stock. If you never end up exercising the option, then your loss is only $ 4 per share.
There are many different kinds of options with different strike prices and different expiration dates. They also have different costs and to find the option that's right for you requires additional analysis. The point to be made, though, is that put options are a very effective tool for insuring your investments during periods of economic turmoil. Without insurance, your portfolio lacks a "safety net" and big losses become a possibility especially in tough economic times.
Unfavorable economic conditions require learning about new investment techniques if one hopes to preserve one's wealth, or even grow it. It's not that options have not been around for a while, but rather that most investors have never even bothered to learn about them (including brokers!) And even less have actually employed them.
Most Americans have insurance for a variety of things – their home, their automobile and their health, to name a few. Sometimes it's mandated by law, but most people find it advantageous to have insurance in the long run. However, it is striking how many people do not insure their wealth even though they worry about it so much. If other important things can be insured, then why not insure investments as well?
Just imagine how different things might be if the dot-com millionaires during the 1990s had been savvy enough to use options to preserve their portfolios !!