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By Mark Bern, CPA CFA

This article is primarily directed toward the conservative, buy-and-hold type investor. At the same time, many of those who consider themselves to be in this category may find the approach I describe here to be contrary to investment strategy. Please bear with me as I believe it will make more sense once it is better understood.

I should point out that I am not predicting an imminent market crash. I suspect that there will be a correction in the short term (which we are experiencing now) of between ten and 15 percent and then another leg higher. The bull market since the bottom of March 2009 is getting long in the tooth; it has now lasted longer than the 2/3 of bull markets since the Great Depression (see this article from Forbes for a great chart). If it lasts six months longer it will be longer than all but three bull markets during that time, out of a total of 15. But with continued intervention by the Fed and other central banks, I can't help but expect one more rally to new highs. I may be wrong and I try not to time the market per say, but when we get this deep into a bull market I find it to be prudent to consider protecting what we have accumulated. Better opportunities to add to our positions will come before too long. Right now we need to hold on to what we've got so we can keep building from the current levels rather than risk suffering a huge setback and the need to climb back out of another hole as we did in 2002 and 2009.

First, as buy-and-hold investors, we do our best to select stocks of companies that can weather any storm; companies paying rising dividends, with great balance sheets and sustainable business models that can stand the test of time. We start or add to our positions in these superior companies when the respective stock appears to provide a good value. I generally only invest in dividend-paying stocks because, over the long term, a significant portion of the total return on large cap stocks in general (S&P 500, for example) comes from dividend and reinvesting this income stream to compound our returns. It can amount to more than 50 percent of the total return over a lifetime of investing according to this article by Dreyfus.

Secondly, I am more concerned with the loss of capital than any other aspect of investing. That is why I try to be selective. One bankruptcy can wipe out a significant piece of your hard earned returns. I know. During my early investing years I experienced one such event along with more than a few major losses from companies with unsustainable growth prospects. That was my learning period. I learned that avoiding losses keeps the portfolio growing and compounding at a much better clip in the long run.

Third, I have found that using options correctly can add some additional return. The key word in that sentence is "correctly." Used for speculation, options are a very high-risk form of gambling. But, used correctly, options can either add income to a portfolio or provide protection against downside portfolio risk.

Finally, like most investors, I dislike those inevitable bear markets (or crashes) that seem to be happening more and more often. While a true, buy-and-hold investors does not dump their respective stocks during a crash, it is still painful, nonetheless. It also can take a year or more to regain the lost ground given up during the sell-off. It is also expensive to buy puts on the companies that we hold long-term in an attempt to reduce our exposure to major market downturns. That is why I have developed a method that is far less expensive to employ and holds the potential to pay for itself, as you will see a little later in this article and future articles on this topic where I will provide real life examples.

Hopefully, we all diversify our portfolios in order to minimize the risk of loss from any one sector, industry or geographic exposure. Thus, we end up with a basket of equities from at least eight sectors that derive revenue from widely dispersed sources around the globe. As many of my readers know, I prefer stocks of companies that are traded on U.S. exchanges because I understand the accounting rules. If you would like to understand more about how I go about selecting my stocks please see this article on that subject. I also prefer companies that have a global footprint, thus providing greater geographic diversity to my portfolio and allowing me to capture growth from around the world not matter where it happens.

Up to this point, hopefully, my approach seems conservative and built on a solid foundation. I promise that it will remain that way, but some may need to open up their respective minds to something new in order for the next part to make sense.

I will now try to explain why holding a diversified basket of put options for stocks of companies that we would otherwise never buy can provide more downside protection for less cost than trying to use options for the companies that we own. Think about this for a moment: we try to buy and hold the best companies available that we expect to go down less, on average, that the overall market, pay a constantly rising stream of dividends, have sustainable advantages and great balance sheets; why would we want to bet against ourselves? I propose that we buy puts on companies that have the opposite traits: companies for which the respective stocks get hammered in every downturn, which pay a dividend that often gets cut during recessions, that have excessive debt loads and that are not experiencing consistent revenue growth.

Since these companies' stocks are more likely to fall further in any significant downturn, we can buy out-of-the money put options for much less while achieving similar levels of downside protection. It is important to note that I am not recommending that an investor try to protect a diversified portfolio buy selling put options on a single stock. While I will highlight prospects in each article in this series, it is my intent to build a basket of put options from a diversified group of stocks that should, in aggregate, fall much faster and much further than a portfolio of well-selected stocks as described above. We won't try to match sector by sector what we own. The point is to make sure to hold a group of put options from a diversified group of stocks representing a relatively broad swath of the economy. We may have a miss or two, but on the whole we'll achieve our objective.

On the other side of the coin, some of these companies may not require a major crash to take their respective stock prices down significantly. As I mentioned earlier, if one or two of these stocks takes a good tumble the entire cost of our put insurance could be paid from those gains.

So, why am I writing about this strategy now instead of waiting for the top I expect to materialize? It may not happen. No one knows for sure what will happen next. We may be in the early stages of a major bear market but none of us may know with any certainty for several months. Then, you may ask, why did I not write about this earlier when the market was higher? Quite simply put, I don't think I could have gotten anyone's attention. Expectations were too high and there was very little to remind us that these things can and do happen. The market had been rising uninterrupted for all of 2013. The S&P 500 index is down about 5.6 percent from recent record highs as I write this article. Not enough to get overly concerned yet, but maybe enough to get people thinking about the risk that is inherent in equity investing. Granted, it would have been better to have already placed at least a portion of the positions.

But, even if we are already in the early stages of a bear market and nearing another recession (which I don't think is happening yet), it would make sense to begin the process of protecting the 95 percent that we still have left. I also don't advise investors to initiate their entire protection position all at once. There are always rallies to take advantage of along the way and, assuming that we still have higher highs coming in the future, it would be more prudent to take only a portion of the position today and wait for a better opportunity to buy contracts at lower prices in the future. If you decide to initiate positions soon, I would suggest averaging into the positions buying no more than a third of the full position you intend to use for each contract. I am starting by purchasing about 25 percent of the full positions at this point, just to give you some perspective.

There is still another reason for beginning this process now: with the tapering of QE by the Fed, it seems to me that investors are becoming more selective; meaning that the best companies will retain value better and the worst companies will be passed over. That should translate into lower prices for many of the companies I will be writing about in this series. It also means that fundamentals are beginning to matter again and that is a good thing for those of us who actually do their homework. As the tide of QE rises and falls in the future, only the best companies will rise while the companies with holes in their business models will begin to take on water and sink. That is why I believe that this strategy has the potential to not only protect against loss, but it should prove to be a very efficient and cost effective method as well.

Over the coming two weeks, I plan on providing ten stock options (one or two per article) for companies that are not well-positioned to weather a bout of economic weakness. I suggest that one should select at least eight positions to get a decent diversified basket either from the ten to be provided or similar companies. I will suggest an option contract for each with a buy up to price for each that should provide a balance between potential return and initial cost.

The last item I want to discuss in this article is how to decide how many contracts you will need to buy to protect your portfolio. I will discuss the cost of this strategy in the next article as I get into examples. To start, it depends on whether you want to be fully hedged or only partially hedged. Either is fine. The less hedged you are the more downside risk you are exposed to in a major crash. On the other hand, the more hedged you decide to be the more it will cost you and that will reduce your potential returns if no crash occurs during the holding period. I fully expect a significant downward plunge in stocks sometime during the next two years. My expectation is for a drop in the S&P 500 Index and DJIA Index of at least 30 percent during this time frame. It could be worse or milder, but that is the basis of the coverage I will recommend. If it is worse, applying this strategy will continue to provide protection. If it is less, this strategy may only provide partial protection. But partial protection is better than no protection in the wake of a 25 percent market decline. You can make adjustments to my suggestions in order to align with your own expectations. I will explain in greater detail how to do that in the next article.

I will be recommending contracts that are nearly one year in duration; mostly January 2015 expirations. If there has been no setback by that time it may be necessary to roll over our positions into January 2016 contracts either later in 2014 or early in 2015. For each contract on each company's stock I will provide an expected return on the option in the event we experience a major crash. Thus, if you decide to choose eight stocks and want to be 100 percent hedged; you would assign a value of 12.5 percent to each position. Then you take the total value of your portfolio multiplied by .125 (12.5%) to determine the portion of your portfolio you want to protect with each of the eight selected option contract positions. Next you multiply that amount by .3 (30%) to determine how much of a downside loss you want to protect against. Using this dollar value, you divide this amount by the expected gain per contract to determine the number of contracts you will need to purchase in total. Remember, I am suggesting entering these positions a little at a time because I believe we will eventually get at least one more good rally before we find the long-term top for this bull market. I will provide examples of this calculation based upon a $100,000 portfolio to keep it simple for adjustments to the numbers to reflect the actual size of your portfolio. If your portfolio is closer to $500,000, for example, it will simply require you to multiply each position I suggest in the examples by five.

Now if you only want to hedge a portion of your portfolio, say 50 percent, the adjustment will be to multiply the contracts you calculate for 100 percent coverage by .5 (50%), or whatever by percentage of your portfolio you want to protect. Again, some protection is better than nothing.

I will also provide a basic tutorial about options used in this manner in the next article. If you would like to learn more about options before that (probably Wednesday), a good discussion of the topic can be found in this article that I wrote in 2011. It is dated, but the explanations and principles still apply and the comments by readers add tremendously to the education.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

Source: Protecting Your Equity Portfolio For Less - Part I