Secret 37THE SECRET OF PORTFOLIO INSURANCE

The easiest way to protect a stock portfolio from a market

decline is to buy put options. If you already own a put portfolio as

part of your option buying activities, you already have some

built-in insurance.

Over the years in the many lectures and presentations that I

have made, I have warned investors always to hold some puts in

their portfolio in order to protect their stock positions and mutual

funds from unexpected market declines. My reference has always

been to the bear market of 1973–1974, where many large

mutual funds lost 80% of their value.

Those warnings did not seem very believable to many investors

until the bear market of 2000–2002 when many Nasdaq

stocks dropped 90% in value and the disastrous attacks of September

11, 2001 sent the market into a nose dive.

Because of unpredictable variables, described in chaos theory,

we never know what other event could send the market or

individual stocks, such as the airlines, into a tailspin. Another

terrorist attack, possibly on a greater magnitude, or a gigantic

earthquake in a population center such as Southern California

could see the market lose a quarter or more of its value. (An

earthquake as recent as 1976 killed over 500,000 people in

China.)

To add gasoline to the fire, there is evidence to support a potential

depression. (Read Robert R. Prechter Jr. ‘s Conquer the

Crash.) Such events are possible. Although we hope never to see

such events in our future, we should be prepared for such uncertainties.

Some theorists claim that a nuclear attack or gigantic

earthquake in a major population center in the US is inevitable

over the next twenty to fifty years.

Consequently, a put portfolio is not only a good speculation,

but also a good insurance policy to offset some of the risk of your

portfolio. We buy insurance for our home, our health, our automobile

and even our vacations. Why not buy insurance for our

portfolio that took a lifetime to develop?

Many saw much of their portfolio vanish in the severe bear

market that started in 2000. What if they had had some put

insurance?

However, most people have a tendency to buy too much insurance. You buy insurance for a potential disaster. You don’t

need total protection. What you need is a safety net. Buying

cheap out-of-the-money puts can provide that net. Therefore,

your put insurance will not be a big investment, just a very small

percentage of your portfolio.

Nevertheless, when buying these puts, make sure they are

undervalued and have a decent probability of profit and delta. Try

to make your put portfolio a separate profit center even though it

is designed as an insurance policy. Here is a rare occurrence

where your insurance policy could actually generate a profit even

if you don’t see a disastrous decline. Puts purchased in such a

portfolio do not have to be the same as the stocks you own. As a

result, you can be a true bargain hunter.

You can also buy puts on the stocks you own, especially

when a stock is vulnerable to a decline and you do not wish to

sell the stock. Again, try to buy cheap out-of-the-money puts.

They won’t give full protection but will act like a deductible insurance

policy, and for a small price you get a lot of reassurance.

Buying such puts may not be a good investment, but it will

be when the market is in the depths of decline where you are

ready to panic out of the market right at the wrong time. Puts

will give you the reassurance that will enable you not only to

sleep at night, but also to avoid panicking and selling your stock

when you shouldn’t, usually at a market bottom.

One observation I have made over the years is that sometimes

you are given a second chance to buy some put insurance.

During severe market declines if you act quickly, you sometimes

can still buy puts at reasonable prices. Again, it is great to have puts in your portfolio just for peace of mind, but some sizable

profits can be made, particularly during a severe market decline,

if the situation is right.

For example, after the Twin Towers attack during the first

day after the market opened, even though many stocks gapped

down on the opening (i.e. the airlines), there were many stocks

that temporarily held up in price that took much bigger hits in

the next few days. There was time to buy puts that paid off big

time. But, again, quick action is needed.

The easiest way to protect a stock portfolio from a market

decline is to buy put options. If you already own a put portfolio as

part of your option buying activities, you already have some

built-in insurance.

Over the years in the many lectures and presentations that I

have made, I have warned investors always to hold some puts in

their portfolio in order to protect their stock positions and mutual

funds from unexpected market declines. My reference has always

been to the bear market of 1973–1974, where many large

mutual funds lost 80% of their value.

Those warnings did not seem very believable to many investors

until the bear market of 2000–2002 when many Nasdaq

stocks dropped 90% in value and the disastrous attacks of September

11, 2001 sent the market into a nose dive.

Because of unpredictable variables, described in chaos theory,

we never know what other event could send the market or

individual stocks, such as the airlines, into a tailspin. Another

terrorist attack, possibly on a greater magnitude, or a gigantic

earthquake in a population center such as Southern California

could see the market lose a quarter or more of its value. (An

earthquake as recent as 1976 killed over 500,000 people in

China.)

To add gasoline to the fire, there is evidence to support a potential

depression. (Read Robert R. Prechter Jr. ‘s Conquer the

Crash.) Such events are possible. Although we hope never to see

such events in our future, we should be prepared for such uncertainties.

Some theorists claim that a nuclear attack or gigantic

earthquake in a major population center in the US is inevitable

over the next twenty to fifty years.

Consequently, a put portfolio is not only a good speculation,

but also a good insurance policy to offset some of the risk of your

portfolio. We buy insurance for our home, our health, our automobile

and even our vacations. Why not buy insurance for our

portfolio that took a lifetime to develop?

Many saw much of their portfolio vanish in the severe bear

market that started in 2000. What if they had had some put

insurance?

However, most people have a tendency to buy too much insurance. You buy insurance for a potential disaster. You don’t

need total protection. What you need is a safety net. Buying

cheap out-of-the-money puts can provide that net. Therefore,

your put insurance will not be a big investment, just a very small

percentage of your portfolio.

Nevertheless, when buying these puts, make sure they are

undervalued and have a decent probability of profit and delta. Try

to make your put portfolio a separate profit center even though it

is designed as an insurance policy. Here is a rare occurrence

where your insurance policy could actually generate a profit even

if you don’t see a disastrous decline. Puts purchased in such a

portfolio do not have to be the same as the stocks you own. As a

result, you can be a true bargain hunter.

You can also buy puts on the stocks you own, especially

when a stock is vulnerable to a decline and you do not wish to

sell the stock. Again, try to buy cheap out-of-the-money puts.

They won’t give full protection but will act like a deductible insurance

policy, and for a small price you get a lot of reassurance.

Buying such puts may not be a good investment, but it will

be when the market is in the depths of decline where you are

ready to panic out of the market right at the wrong time. Puts

will give you the reassurance that will enable you not only to

sleep at night, but also to avoid panicking and selling your stock

when you shouldn’t, usually at a market bottom.

One observation I have made over the years is that sometimes

you are given a second chance to buy some put insurance.

During severe market declines if you act quickly, you sometimes

can still buy puts at reasonable prices. Again, it is great to have puts in your portfolio just for peace of mind, but some sizable

profits can be made, particularly during a severe market decline,

if the situation is right.

For example, after the Twin Towers attack during the first

day after the market opened, even though many stocks gapped

down on the opening (i.e. the airlines), there were many stocks

that temporarily held up in price that took much bigger hits in

the next few days. There was time to buy puts that paid off big

time. But, again, quick action is needed.