Buy Some Portfolio Insurance While It's Cheap

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 |  Includes: SVXY, TVIX, UVXY, VIXY, VXX, VXZ, XIV
by: Illuminati Investments

We've all seen myriad examples of advertisements claiming you could save money on insurance for your car, house, boat, houseboat, or even yourself, through a wide variety of different life insurance options. I bet there's probably a banner ad for some type of insurance offer lurking somewhere on the browser you're using to read this article right now.

Yet you rarely see advertisements offering insurance on your investment portfolio. I'm not talking about the ill-conceived and ironically-named "portfolio insurance" concept that probably contributed to the 1987 Black Monday crash. Rather, I'm talking about a way to protect your capital, not to mention all the gains you've probably racked up so far this year.

If you've been lucky and/or skillful enough to enjoy most of the rebound off the lows of 2009, you might scoff at the need to protect your assets. You're Midas and everything you touch turns to gold, or Fed Chairman Ben Bernankelstiltskin is spinning debt into gold, or whatever other gilded analogy you'd like to use, so why would you want to implement a strategy that runs counter to this?

Well, there's an old adage in the insurance biz that you have to buy insurance before you need it. And if you buy it when everyone else thinks you don't need it, it will likely be even cheaper. Don't worry, I'm not talking about anything to do with the aforementioned gold producing or hoarding strategies, which have performed so poorly this year and are hardly a sure hedge against declines in equities, especially ones brought about by deflation, however unlikely you may think that might be.

Rather, I'm talking about something that is arguably even cheaper and more effective: buying put options. This has also been a widowmaker strategy so far this year as momentum stocks like Amazon (NASDAQ:AMZN), Chipotle (NYSE:CMG), salesforce.com (NYSE:CRM), LinkedIn (NYSE:LNKD), Netflix (NASDAQ:NFLX), and Tesla (NASDAQ:TSLA) have accelerated well beyond what short sellers using traditional valuation metrics ever could have imagined.

So instead of getting on either side of these steamrollers driven by mostly blindly optimistic analysts, we should probably lean towards a bet against a broader index like the S&P 500, which you can buy puts on through the SPDR (NYSEARCA:SPY) index fund. Thanks to historically low volatility, which is an integral part of option prices and can be measured through the VIX (NYSEARCA:VXX), option premiums are extremely reasonable.

For example, you can buy a December 2014 put with a $180 strike price that expires in just over a year for about $12.30-12.40. Since each contract represents 100 shares of stock, this would cost you about $1250 after typical commission fees. This might seem costly until you realize that it gives you leverage to SPY shares with a nominal value of $18,000.

If you just so happened to already be long exactly 100 shares of SPY, this would exactly hedge your position by giving you the right to sell your shares for $180 each, limiting your downside to just over a dollar a share at today's price of around $181.50. Since this protection would cost you $1250, you could think of the premium being about 7% of the value of your SPY position.

This is obviously quite a drag on someone's portfolio that might be getting used to double digit gains every year, but the very fact that you're worried about missing out on an extra 7% might suggest you could be getting complacent if you can't imagine missing out on any extra gains, not to even mention the possibility of losses.

That's where the benefit of this insurance starts to come in. If SPY declines by 10% next year, this option would be worth the strike price of $180 minus the $163 closing price of SPY, or about $17 times 100 equals $1700 per contract. This would represent a 36% gain on your initial $1250 investment. Not spectacular, but certainly better than the loss you would have sustained without insurance.

However, you can buy options without owning the underlying index, and since options are leveraged bets the payoff rapidly increases the lower the index goes below the strike price. A 20% decline in the SPY would result in a value of about $3500 per contract, or a gain of 180%. In this manner, a relatively small position can protect a much larger, more diverse portfolio against steep declines in the overall stock market.

Say you have an investment portfolio of $180,000 instead. You could use a mere 3.5% of this to buy 5 of the put options outlined above. If the SPY pulls back just 15% next year you would stand to gain almost $13,000, which would offset a portfolio decline of up to 7% and if you were fully invested in the stock market would turn a market matching loss of 15% into just an 8% decrease in overall portfolio value.

This might seem like a loser strategy just to try to limit your potential losses, since if things continue to go well you'll be out the $6250 this position cost. But I feel this is a small price to pay for such powerful downside protection, with the added benefit that the position could start to make money with a large enough decline, and if happily none materializes, can be used as a tax loss to offset capital gains.

This strategy might seem antithetical to the capitalist mantra of making money on the back of a strong business, and it should be tough to revel in the misfortune of others, especially at the expense of the entire economy, but insurance is not about making money through a giant windfall, it's about protecting yourself should the unthinkable happen.

Right now, I believe too many investors are being lulled into a false sense of security and probably think any decline, much less a double digit one, is unimaginable. Don't be one of the three little pigs who thought their homes and livelihoods were safe without insurance, and to continue mixing metaphors, start building some protection for your portfolio with bricks not of gold, but of some more economical options.

Disclosure: I am short CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short CRM through put options, and may take my own advice and buy put options on SPY in the future.