Protecting Your Gains Before the Pending Correction

Feb.17.11 | About: SPDR S&P (SPY)
The market has now doubled the low of 666 on the S&P 500 set in March 1999. We don’t have any "doublers" in our long-term portfolio. We have moved on from most of the stocks bought in that spring and summer. We still own Proctor and Gamble (NYSE:PG) and Coca Cola Co. (NYSE:KO). We are sitting on nice 28% and 33.5% gains in these blue chips. Is it time to take some money off the table?
Every day, the word "bubble" is used to describe some part of the market. Precious metals, commodities, technology, base metals, treasuries or China real estate … how many bubbles can we build before we run out of buyers to support the ever higher prices. Here is the S&P 500 for the last five months.
SPX 2.16.11 Five MonthsClick to enlarge
(Click to enlarge)
This is part of a larger picture. The last two years has been a heck of a ride, what is next. The major interruption of the bottom left to top right chart shown below is late last spring and summer after the Fed’s first efforts at Quantitative Easing ended. The market slumped below the 200-day moving average for over three months.
SPX 2.16.11 24 MonthsClick to enlarge
(Click to enlarge)
It was hard to find optimistic voices and analysts. The future looked bleak. But then Big Brother Ben rode to the rescue with QE2 and miraculously "all is well." It may be, we don’t know. What we do know is the market cannot go up forever. It will correct. Many technical analysts believe the market is too far ahead of itself when it is more than 10% above the 200-day moving average. The S&P 500 crossed that threshold on Dec. 23, 2010. The market is currently 14.8% above the 200-day average. Last April the market topped at 12.5% above the 200-day average.
Does this mean "the party is over?" No, but it means the music is getting louder. We have all had too much to drink. The girls all look prettier. The bartender is close to calling "Last Call!" What should we do? If you are a trader, continue with the trend. It is up and more money can be made if you stay with the trend. Just keep your stop losses tight.
If you are an investor, maybe it is time to take some money off the table. Maybe it is a good time to rebalance your portfolio if you have not. Maybe you should buy some protection. This idea is very simple; you are sitting on some great gains. Why not protect them?
How to do it? Buy a PUT contract against a broad index fund like SPY. This morning you can buy a PUT contract against the SPY ETF for the April $130 strike price for about $2.00 per share. SPY is trading at $133.50 To protect a $100,000 portfolio buy seven contracts at a total cost of $1400 dollars. This represents the right to sell 700 shares of SPY for $130 dollars on the third Friday of April. Seven hundred shares of SPY represents $93,000 worth of equity, making it roughly equal to the value of your portfolio. Of course you don’t have to own the shares, because you will sell the option contract before it exires. We would suggest "closing out" the contract if the value drops to $1.00 This makes your actual risk $700 dollars.
If the market takes a dip the value of the PUT contract increases in value. So as your portfolio decreases in value, your put increases in value making up for your "paper" losses on the stocks you still own. How popular is this idea? As I write this almost 20,000 contracts have changed hands today. That represents over two million shares of SPY, with over $266 million dollars in capital!
This is not foolproof. If the market continues higher, your PUT will decrease in value. But, wouldn’t you sleep better at night with a little "protection?" Giving up 0.7% of potential profits is a small price to pay for a good night’s sleep.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.