If Worried About the Markets, Consider 'Travel Insurance'

Includes: SPY

The “Roundtable” portion of Sunday’s This Week with Christian Amanpour was so troubling that I feel compelled to bring it to the attention of those I care about. (Note: if you want to skip 20-minutes of McConnell and Clyburn providing their ideology and non-answers to Amanpour’s questions, scroll down to the “Roundtable: Debt Divide” video on the left side of the page).

What’s notable about the Roundtable discussion is that each of the four participants, in their own way, reinforced (and amplified) the concerns I had (and continue to have) when I wrote my May 16 post.

Since May 16, the S&P 500 (NYSEARCA:SPY) has declined by a little more than -4.5%. Notwithstanding the frightening views of the “Roundtable” participants, you might at this point be more worried about further declines than you were last May. But you also might think that, with the 4.5% decline already experienced, you’ve lost the opportunity to move to cash and don’t want to do so now for fear of missing out should the market rally based on, say, unexpectedly strong 2nd quarter earnings reports.

A compromise approach might be to view the ‘journey’ of uncertainty over the next 3 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 Chairman Bernanke 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.

This pretty much describes my sentiments and approach in managing client accounts over the summer.

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

Full Disclosure: I hold both long and short positions in SPY at the time of this writing.