Do Markets Correct? Reviewing Your Policies

by: James Gornick

Time to review your Insurance Policy for these turbulent markets moving ahead into 2012. Have your nest eggs been protected? Have you fine-tuned your portfolio in the event of a severe market correction?

Review your options--literally

Using ETFs and certain stocks, you can hedge the indexes or sectors providing prudent buying of put options. Below you will find a list of ETFs from Dorsey Wright and Associates Research. Using options to buy your protections in a market wanting to go higher over these past three weeks of trading seems crazy (right).

Get to know how to use options to insure your positions. Outright Options can be found deeply discounted due to the volatility creeping back into the backdrop of oversold and when issues become overbought. It seems this market is giving both in these past few weeks.

The majority of traders who are new to options can understand the workings of call options with little difficulty; but the put remains a much bigger mystery.

The call tracks stock prices. So if you buy a call at a strike price the same as today’s price per share, your call gains one point for each point the stock rises. It also loses one point if the stock price later falls.

The put does the opposite. The put gains one point for each point the stock loses. So the put’s value moves opposite changes in the stock. This does not make the put more complicated than the call. It is simply the same concept, but profits come when stock prices fall instead of when they rise.

The long put can be very advantageous in a few specific situations. For example, let’s say you own 100 shares of Bank of America (NYSE:BAC). Its value has suffered over this past year, but had risen nicely since you bought it in the low single digits and you want to keep these shares. But you are worried about the risk that your profits will evaporate if the stock price falls. You can solve this problem by buying one long put for every 100 shares you own. Remember that this “insurance put” protects you as its value rises point for point with each decline in the stock.

The trouble with the insurance put is that you have to pay for it. There is no free lunch, even when they say it's been discounted due to volatility. This insurance put effectively has a premium. Think of it as the deductible. But there is a solution! It is a strategy called the collar (COLLAR). In this strategy, you buy the put but you also sell a covered call.

This is where it gets a bit complicated, because now you own 100 shares of stock, plus a long put, plus a short call. If you understand covered calls, adding the long put is just an extension of the strategy. The cost of the long put is covered by the income you get for writing the short call. If stock prices rise, the call is exercised and you keep the premium plus your capital gain on the stock. If the stock price falls, the short call expires worthless and is all profit; and your insurance put offsets losses. Also, that insurance was free in the sense that it was all or mostly paid for by the short call.

These various permutations of option strategies are endless. For example, you can stretch the risk with ratio writes (selling three calls versus 200 shares of stock, for example, which sets up a 3:2 ratio write); this not only pays for the two insurance puts you need to protect the 200 shares, but provides even more income from call premium.

To reduce the greater risk from the ratio write, you can make it into a variable ratio write, which is the same idea but involving two different strike prices.

Option strategies demand study and analysis; you need to make sure you know the risks as well as potential profits before moving ahead. However, once you know how to cover your risks, options can reduce or even remove all of the danger from ownership of long shares. It’s a matter of learning the strategies and figuring out how they work in every possible scenario.

Readers can certainly take consensus with Todd Harrison of Minyanville to stay the course on the side of safety. The cattle / herd is going to move from bond funds toward stock funds, as was tossed around by Steve Reitmeister out of Zacks last week in Seeking Alpha. It was a good call made by Steve.

There are many oversold conditions warranting bullish calls made by Steve Reitmeister. We believe there are many reasons to use Options to hedge through these next several quarters into 2012 - 2013, as a prudent suggestion moving forward.

Good financial planning may prepare you for potential 15-65% corrections. Especially with the uncertainty of debtor nations starting to stack up. Just in the news coming into the weekend-- Italy is joining the countries catching the Spanish Flu and Greek Quarantine may come next, if solutions don't come quick.

Just the thought of the looming U.S. state and local municipal bond defaults predicted by Meredith Whitney are enough to keep the safety guns loaded.

Taking positions in Options against long positions in your portfolio are sound protective measures for moving forward in these markets.

Corrections within the commodity sector are being signaled with moves in Gold and Oil, along with currencies of inverse moves seen.

Furthermore, signals by Harry Dent (The Dent Method); are up on the radar. Dent has predicted the market's upturns and downturns since early 1990s with an uncanny accuracy. Look closely at the provided data charts of population and spending projections by Harry Dent. These charts have sent a resounding message for the 2011 markets.

Again, Dent's most recent market call is based upon demographic population and changes within economic structures of aging and changing work-force.

In our world, we are now forced to achieve more with less-- more profits with less laborers due to a dwindling of the population. The problem seen for the U.S. and other nations are measured by many economists by the lack of employable folks having employable skills, or the ability to obtain the skills keeping our nation's economic outlook in question with all the others.

The theory of having at least four working for each one who wishes to retire remains a hurdle.

Nations who wish to economically survive need workers ultimately from somewhere, as pushed by Nobel Professor Joseph Stiglitz. Stiglitz becomes critical to point out the need for the happy factor of the worker and the productivity levels, if a nation seeks to support social benefits. But with this current environment, with these numbers, state nations cannot keep to their economic plans due in part to not enough happy workers.


Austerity yields at what level? You can ask -- at what levels will they come in 2012 and 2013? Will we see a range between 4.3% - 8% yields? Are the risk for defaults bringing in the Bond Barons, such as Bill Gross from PIMCO, funds to still remain on the sidelines for clearer safety?

Bill Gross, who will seek the highest yields at the greatest safety, is known for his fund's track record of performance. Yields at the price of the public and private sector jobs are supporting re-payments to stave off defaults of each Nation concerned, buoy the repayment of debt reconstruction; eventually though they must default. Go here to gather Bill Gross's latest thoughts.

The impact and pressure it will have on the markets moving forward are self-evident; especially the emerging markets trying to support the already developed nations.
In Summary:
Be protective, as the big money is moving to hedge their positions as we enter into the last two quarters of 2011 and moving into 2012.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.