Is Crash Protection Worth the Cost?

The market's been moving straight up all month, and when that happens, the last thing most investors are thinking about is protecting their portfolio from potential losses. But forgetting to consider that stocks can fall just as fast as they rise can be a huge mistake, especially because buying protection against a stock market crash gets a lot cheaper after a big move up in the stocks you own.

Wake me up when September ends
A lot of investors went into September thinking that the next stock market crash could be imminent. With a terrible August, September's historical reputation as the worst month for stocks brought back memories of the market meltdown two years ago.

At least so far, that's turned out to be a completely false alarm. The S&P 500 has made up all of its August losses and then some, rising more than 9% so far in September. Barring a huge drop this week, this month could prove to be the best September in 70 years.

But if you think the market's out of the woods, there's still plenty to worry about. Although the economy has shown signs of life, the unemployment picture remains stubbornly weak. The U.S. dollar has dropped precipitously in recent sessions as the Fed signaled a potential need for further quantitative easing in order to improve economic growth and avoid a disastrous deflationary spiral. While the bulls party like it's 1999, skeptics point to record highs in gold and extremely low interest rates as signs that all is not well in the financial markets.

An options play for a contrarian mind-set
If you fear that the markets are more likely to pull back than start a new rally, then you might be tempted to sell and take some profits. But if you'd rather not miss out if the market keeps advancing from here, another choice you have is to use put options.

Put options give you the right to sell shares at a price you specify anytime between now and the options' expiration date. All you have to do is pay an upfront premium for the options. If the stock goes up, then you still reap the profits; the only loss from the option is the premium you paid. If the stock goes down, however, you can exercise your option and limit your losses to whatever amount you feel comfortable with.

So is now the right time to buy protection for your stocks? Let's take a closer look.

Are these stocks vulnerable?
As examples of stocks for which protection might make the most sense, I turned to AlphaClone, which tracks what the professional investors who run hedge funds and mutual funds are doing with their portfolios. In particular, I wanted to look at the stocks that were being sold by the most funds in the most recent quarter. Here were the top five, along with how much it would cost to protect yourself from losses on those stocks with put options:

Source: AlphaClone, Yahoo! Finance. As of market close Sept. 24.

Notice that even with market volatility levels having fallen recently, put options on individual stocks still aren't ridiculously cheap. To protect yourself from any significant drop in your shares, you'll pay 5% to 8% or so for options lasting just a couple of months. That's still a pretty high price to pay for complete protection.

Of course, these stocks still have major outstanding issues. Transocean and Massey are both associated with disastrous events, while Monsanto has suffered from generic competition on its important Roundup product. Seagate and Garmin both see threats from competitors as well, as solid-state technology supplants traditional hard disk drives and smartphones tread onto GPS device territory.

On the other hand, broad-market options are somewhat less expensive than protection for most individual stocks. A put option on SPDR Trust (NYSE: SPY) near the current share price of $114 would cost less than 3% of the share price, while a similar option on the iShares Russell 2000 (NYSE: IWM) would cost around 4%.

Buying put options can be a smart way to hedge your market risk on a temporary basis. But as permanent protection, put options get expensive in a hurry. If you really have so much stock exposure that you're constantly worried about potential losses, the better choice is to look closely at your asset allocation to make sure you have the right mix of stocks for your goals and comfort level.

Just because those financial TV shows say something doesn't make it so. Matt Koppenheffer explains why the smart move is not to listen to stock market stupidity.