By Michael Higdon
The European crisis, fears of a double dip recession in the United States, and September being the worst month for stock performance have been some of the recent headwinds in the market. Even though last week was a good week for equities, pressure will still be to the downside. Holding on to a losing stock or in a losing market is not the way I like to invest, but there are often circumstances that prevent a sale. For instance, sometimes you might not want to sell for tax purposes, or maybe you have to be long the market in your portfolio. I want to highlight three ways to protect your portfolio in a down market.
The first way to protect a portfolio in a downward-biased market is to go defensive. You should think like a portfolio manager who is under constant pressure to be ‘in’ the market. If the PM thinks stocks are going down, he will probably sell the volatile, cyclical names and buy companies with revenue that is not quite as tied to the economic cycle. If someone loses a job, he or she is probably not going to buy the latest Iphone, but will continue to buy soap. The defensive companies sell items that people buy regardless of their economic situation. Sectors that perform better than the market during a downturn are the staples, healthcare, and utilities sectors. For example, from April 29, 2011, until August 8, 2011, the SPDR S&P500 (NYSEARCA:SPY) dropped 18%. During that same time period, the Select Sector Utilities SPDR (NYSEARCA:XLU) dropped 9%, the Select Sector Staples SPDR (NYSEARCA:XLP) dropped 9%, and the Select Sector Healthcare SPDR (NYSEARCA:XLV) dropped 14%. Even though these three sectors declined in value, they showed relative strength against the overall market. Usually stocks in these sectors are not as volatile as the market. Additionally, the companies within these sectors have dividend yields above the general market. This helps in two ways. The first way is rather obvious. Some people will buy the stock for the constant income provided by the dividend. Another benefit is that these dividend-paying stocks often have attractive valuations as well. This is partly due to the fact that the industry is more mature and growth opportunities are less plentiful, but the stable dividend and low price paid relative to actual earnings makes for a good investment. The first way to protecting a portfolio is looking for companies that are defensive that pay a nice dividend.
The final two strategies are more advanced and use options to reduce risk. Many people think that options are risky, and they are risky if they are not used correctly. Options also allow the investor to manage risk. The first way to protect your portfolio through options is to buy calls on the volatility index (VIX). Usually the VIX and the stock market are inversely related. When the stock market goes up, volatility usually goes down. When the market goes down, volatility usually goes up. This is why people refer to the VIX as the “fear index.” When you buy calls on the VIX, you will make money when volatility increases. Since they are inversely related, this can be used as a hedge against your long equity positions. The proper time to buy volatility options is when volatility has come down so you will not have to pay as much premium for the hedge. Usually this is when the market has risen in the short term, which makes it the optimal time to buy. Last week’s long trend in the market may be signaling a good opportunity to buy options and protect your portfolio.
The second strategy using options to protect your portfolio is selling calls on the equities that you own. If you own Apple (NASDAQ:AAPL) and do not want to sell it, you can sell calls on it. When you do this, you are lowering your breakeven point. If you bought Apple at $350, currently trading for $412, you could sell the $420 strike October call for $11.35. Your breakeven point would be $338.65. If the stock does not get to $420 by October expiration, you keep the stock and the $11 premium. If it hits $420, you will have the stock called away, but you would still keep the premium that you collected from selling the call. The strategy gives you about 2.8% downside protection from the premium and allows the stock to appreciate some before it is called away. This is a good strategy in a market that is declining because you are selling the position after a rally in price within a downtrend. You want to pick strikes that are out of the money but not so far out of the money where there will be little premium. You need to have an idea of how far the stock could go, and then sell the strike price above it. Selling calls on positions that you own is a way to protect yourself when prices are falling. The caveat here is that if the market rebounds aggressively, your investment will not benefit after it reaches the strike price.
I have presented three ways you can protect yourself in a market that is falling. I would only recommend these strategies in this falling environment. I believe the US equity market is currently at an inflection point. If we head higher this week, then this downtrend could be broken, and these strategies would not be as effective. If we get some selling pressure this week, then these strategies should work well. Being defensive, buying VIX calls, and selling calls on positions that you own should provide some protection in a falling market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.