Worried About the Markets? Consider 'Travel Insurance'

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 |  Includes: SPY
by: JHLLC

There's certainly enough to worry about this summer. Since reaching a 52-week high of 1370.58 less than two months ago, the S&P 500 had declined by roughly 7.5% as of market close last Friday. And with increasingly alarmist talk of debt crises both here and abroad, one might understandably be worried about even further declines ahead for the S&P.

But investors holding equities today might also think, with a drop of 7.5%, that they have lost the opportunity to move into cash. Besides, if they move into cash now and the market rallies on, say, strong earnings reports in July, they'll miss out on the gains.

A compromise approach might be to view the journey of uncertainty over the next three months the same as you might view the uncertainty related to an expensive vacation trip. You can, in effect, purchase "travel insurance" to mitigate the effects of any "hurricanes" that may occur in the markets over the near term. And with forecasts by the Federal Reserve and others of a stronger second half for the economy, short-term insurance may well be all that you need.

Here's how it works. Say you hold a mutual fund or ETF (like SPY) that closely tracks the S&P 500 index. As of close of market last Friday, SPY was trading at $126.81 a share. You could purchase a put option on SPY with a strike price of $127 that expires on September 16 for $5.02. This would assure that the value of your investment in the S&P 500 would be worth at least $127 on September 16. But you would have paid a 4% "insurance premium" for that protection.

If that seems too hefty of a price, you could reduce the level of insurance by simultaneously selling a September 16 put with striking price of, say, 114 for $1.55. This would protect you from a 10% decline in the S&P 500 between now and September, with a net cost of $5.02 - $1.55 = $3.47. This equates to about a 2.7% premium for the travel insurance to get you through September. If the stock market rallies, you will participate in the gain. If not, your loss will be 2.7% plus any decline beyond 10% in the market.

The strategy of buying a put and simultaneously selling a lower strike put with the same expiration date is known as a "bear put spread" in the trade. It is a way to offer protection for an investor that is bearish in the short term but bullish in the long term.

Would it be worth a couple of percent points to you to invest in this type of travel insurance? It all depends, I suppose, on how bad you expect the weather to get.

Disclosure: I am long SPY.