You're Taking More Risk Than You Think

Here's a question for you: Would you cancel your homeowners' insurance to save a few bucks?

How about skipping the insurance the next time you buy a new car?

Sounds like crazy talk, doesn't it? After all, houses and cars are big investments. And the risks of a fire or theft or a crash are real. Going without insurance on major investments like these would be a really bad financial move.

It's a no-brainer, right?

So why isn't your investment portfolio insured against the risk of another market crash?

Oh geez, what kind of scam is this?
It's not a scam at all. What I'm talking about is a straightforward approach that's widely used among professionals -- using options to hedge the risk of a portfolio.

I'm not saying options are as important as homeowner's insurance, but the principle is the same. And before you tell me I'm crazy for even suggesting that individual investors consider them, stop and hear me out. (Besides, I've heard it before.) There's nothing inherently bad or risky about options, and once you understand them they can be a valuable component of your investing toolbox.

An option is simply a security that gives you the right to buy or sell an underlying stock at a set price -- called the strike price -- by or before a specific date. They come in two flavors -- puts (which give you the right to sell), and calls (which give you the right to buy), and are available at a wide range of strike prices for many big- and not-so-big-name stocks. The price you pay for the option itself is called a premium.

That's the basic lingo. Now, using put options as insurance can get expensive if you do it for every holding all the time, though there are ways to offset that. But if you happen to own a portfolio of stocks at a moment when the market is looking kind of peaky (like, oh, maybe now), buying puts on the major positions in your portfolio locks in your gains for a set period of time, even if the market plunges.

Having your key holdings insured like this can benefit you in a few different ways. Obviously, if the market does take another swan dive, you'll be able to sell at an advantageous price. But not so obviously, you might be more confident about what you do with the rest of your portfolio. And further, in the event we hit another panicky moment like last March, you'll have the confidence to overcome the panic and take prudent, profitable actions.

Wouldn't you like to be able to do that? You can.

Why you need to think hard about this
I'm still, despite everything that's happened in the last year-plus, a believer in the long-term wealth-building power of stocks. I think anyone who is more than seven or so years from retirement should have most or all of their long-term savings in the stock market.

At the same time, the economy is still fragile. The risk of a "double-dip" recession -- that things will get worse before they really get better -- is real, and with that comes the risk of another major stock market plunge. The memory of the drops many stocks took from the market's peak in October of 2007 to the lows of last March is still too fresh:

Stock

Highest Price in
October 2007

Lowest Price in
March 2009

% Drop

Apple (Nasdaq: AAPL  )

$189.95

$83.11

56%

General Electric (NYSE: GE  )

$42.12

$6.66

84%

Starbucks 

$26.84

$8.27

69%

Wells Fargo (NYSE: WFC  )

$37.47

$8.12

78%

UnitedHealth Group (NYSE: UNH  )

$49.69

$16.35

67%

Las Vegas Sands (NYSE: LVS  )

$144.56

$1.42

99%

Sirius XM Radio (Nasdaq: SIRI  )

$3.69

$0.13

96%

Ford Motor (NYSE: F  )

$9.20

$1.70

81%

Source: Yahoo! Finance. Prices shown are the highest or lowest closing price of the month indicated.

It's true that most of these stocks have since recovered somewhat. But still, what if you had an emergency back in March -- like say, getting laid off -- and needed to tap your savings right away?

Somebody was selling GE and Starbucks and Ford in early March. What if it had been you, and you had really needed that money?

How much risk are you really willing to take right now?

If the answer is, "Less than I'm taking today," we can help. Motley Fool Options teaches you exactly what options are, and how to use them. Just drop your email address into the box below for more information.

Fool contributor John Rosevear owns shares of Apple and Ford. Apple, Starbucks, and UnitedHealth Group are Motley Fool Stock Advisor picks. UnitedHealth Group is a Motley Fool Inside Value selection. The Fool owns shares of UnitedHealth Group. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a non-optional disclosure policy.


Read/Post Comments (5) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 07, 2009, at 6:23 PM, mattack2 wrote:

    Apple has not just "recovered somewhat", up until today it has recently been HIGHER than your "highest price in october 2007" price.

  • Report this Comment On December 07, 2009, at 8:42 PM, TMFMarlowe wrote:

    mattack2: Yeah, I know, I'm an AAPL shareholder. The point didn't seem important enough to call out specifics on each stock.

    Thanks for reading.

    John Rosevear

  • Report this Comment On December 08, 2009, at 10:33 AM, raju3864 wrote:

    I do appreciate the author's point.

    However, there is a fundamental difference between a "car-crash" or "home roof leak" and "stock market crash". While the first two things are irreversible on their own - a wrecked car cannot become roadworthy unless you put money in repairs, a stock market crash can recover on its own (and it does happen sometimes). Hence people at large don't insure their investments through options or other means, and are willing to carry the risk.

    Call it human nature or whatever!

  • Report this Comment On December 08, 2009, at 10:35 AM, raju3864 wrote:

    I do appreciate the author's point.

    However, there is a fundamental difference between a "car-crash" or "home roof leak" and "stock market crash". While the first two things are irreversible on their own - a wrecked car cannot become roadworthy unless you put money in repairs, a stock market crash can recover on its own (and it does happen sometimes). Hence people at large don't insure their investments through options.

  • Report this Comment On December 08, 2009, at 12:18 PM, TMFMarlowe wrote:

    raju3864, I totally agree. It's not an ideal strategy for normal folks in normal times. BUT: If one is near retirement, or worried about being laid off and having to tap a nest egg, AND one is worried about a major market correction, buying some puts can bring great peace of mind. And it's easy to do once one understands some basics.

    Thanks for reading.

    John Rosevear

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