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Safe Investing Requires Put Options For Downside Protection

There is a common misconception that stock options are risky and complicated. Actually, that is true; the can be both risky and complicated, but they can also be very simple and reduce the risk that we all face when investing in the stock market.

Here is a simple way to use put options to protect your investments from disaster. But before we begin, there’s an obvious prerequisite. You have to have investments in stocks or ETFs that have options. If your investments are in mutual funds, that is a little harder, but we’ll cover that another time.

The first step is to get a stock chart of your investments. You can go to Yahoo Finance, BigCharts.com, StockCharts.com, or your brokerage. You need to be able to look at your investments along with the 20-day and 50-day ETFs to Reduce Downside Volatility moving averages. On Yahoo, click on Technical Indicators and select Simple Moving Average (SMA) and type in 20 and 50, and then click Draw.

If the price of my stock or ETF falls to the 20-day SMA and closes below it, I like to add a few Put options — perhaps a third of my position. If the stock then continues down and heads toward the 50-day SMA, I’ll add another third. If the price closes below the 50-day SMA, I’ll add another third.

Let’s say I have 600 shares of SPY, the ETF that mimics the S&P 500 index. This is a core holding of my retirement savings. I don’t want to sell it every time the market burps; that would incur extra taxes for short term gains. And, of course, I don’t want to lose my retirement in a disaster. If the price of SPY falls to the 20-day SMA, I will buy two Puts at a strike price that is roughly equal to the price of the ETF. This is referred to as “At The Money”. I buy puts with at least 60 days till expiration. If the price continues to fall, I’ll add more Puts. If the ETF closes below the 50-day SMA, I will have six Puts in place, protecting my downside. If the downturn is dramatic, I may even add more Puts, actually taking advantage of the downturn for additional profit.

Let’s look at an example. Suppose SPY is trading at 110 and starts to fall. The 20-day SMA is at 105, and when it closes at 104, I would buy 2 of my Puts. If SPY turns around, I would sell the Puts perhaps for a small loss. If it continues down, I’ll buy 2 more at the 50-day SMA at 100. If it closes below 100, I’ll add 2 or more additional puts. Sometimes the price falls faster, and I might add puts faster.

The reason I pick the 20-day and 50-day moving averages is that they often act as support for the price. Often the price will fall to one of the moving averages and bounce off. If it doesn’t bounce off, then it’s a pretty good indicator that the ETF is falling much further and I want my Puts in place.

Here’s what happens. For those puts, you would pay perhaps $3 each. Since each put covers 100 shares of the ETF, you need 6 puts for a total of $1800. That is your insurance premium to protect the $60,000 investment, and the most that you can lose. If the price continues down, your puts will increase in value to offset your loss.

They will cover the loss at a rate of 50% early on, but as the price continues to fall, they will eventually cover your falling ETF dollar for dollar. When the price starts heading back up you can sell back some puts for a profit that covers much of the loss in the ETF. When it crosses back above the 50-day SMA then you will want to sell the bulk or all of your Puts and get back much of the $1800 premium.

You don’t have to suffer the 40% portfolio losses that many people did in 2008. It is difficult to perfectly time the market, but with some knowledge, you can use Put options to protect your investment from disaster.

And of course, this information isn’t a recommendation to buy or sell stock, ETFs, or options. Do your own diligence before investing anything. I strongly recommend paper trading before investing money into a new strategy. Check out the CBOE website for their paper trading tool.

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