Market Beat: Portfolio perfection
There are many ways to protect a portfolio from downturns. Markets regularly go through cycles of volatility and inevitable downturns. Bull markets go up and bear markets go down.
The term hedging goes back to medieval days when property owners would plant hedges around their land for protection. Hedging is an investment term used today. To hedge means to use some type of defensive strategy for your holdings.
Options are just one tool that can be used for hedging. Options are certainly not suitable for all investors and require a thorough understanding of how they work to use them effectively.
There are two types of options, puts and calls. The buyer of a put has the right, but not the obligation to sell the underlying stock or ETF at a set price known as the strike price, by a certain date, called the expiration. The put seller is obligated to buy the underlying on those same terms. A call buyer has the right to buy the underlying while the call seller must deliver the underlying.
Puts can provide protection as the price of a put will rise when the price of the underlying stock or fund falls. The biggest disadvantage to buying puts for protection is the cost. It’s kind of like having insurance, the premium costs some money, but you’ll be glad you have it if needed.
Selling call options on securities that you already, known as covered calls can provide some downside protection, but it is limited to the amount of premium received. The disadvantage to writing covered calls is that in exchange for income you limit your upside potential.
Covered calls and puts can be used together in a strategy known as the collar. If you decide to collar one of your stocks or an ETF, you limit both the upside and the downside like placing a collar on it. One advantage to using collars is that they can be placed at no cost. The premium received from selling the call option can be used to purchase the put option, so they can be used without cost. The disadvantage is that your upside potential is limited by the strike price selected for the call option.
Collaring for certain time frames can work well as a hedge. If you’re concerned about an upcoming event like a Fed meeting, an election or trade talks that could rattle the market a hedge might be a good idea.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.