The stock market has been climbing at a breakneck pace, hitting new records on a nearly daily basis. Even though much of those gains have come from underlying fundamental business strength and positive outlooks due to extraordinary events like corporate tax cuts, some investors fear that the market has come too far too quickly, boosting risk to uncomfortable levels. That's leading even some long-term investors to consider whether it makes sense to sell out of the market.
If you're scared that the stock market is setting itself up for a crash, there are things you can do to protect yourself that don't require the extreme step of selling off your stock holdings. By using a simple strategy involving options, you can reduce the risk level in your portfolio. And although it might seem counterintuitive with the market at all-time highs, you can implement that strategy more cheaply now than at nearly any other time in history.
Buying put options for protection
A put option gives you the right to sell shares of stock that you own at a chosen pre-specified price for a set period of time. For instance, if you buy a standard put option with a strike price of $100 and an expiration date in mid-March, then you have the choice of exercising that option anytime in the next two months, selling 100 shares of stock and receiving $100 per share in cash.
Buying a put option when you own the underlying stock helps you reduce the risk of your holdings. Say in the example above that the stock in question currently trades at $105 per share. If the price goes up to $115 in the next two months, then you won't exercise the option, because you can sell your shares in the market for $115 rather than taking the $100 you'd get from using the option. But if the price falls to $95, then exercising the option provides partial protection against that loss, as you'll be able to exercise the option, get $100 per share, and avoid the $5 in additional losses that you'd suffer if you sold your stock at the prevailing market price.
Why now's an attractive time to consider put option strategies
To be clear, you can't get the protection that put options offer for free. You'll have to pay a premium to buy a put option, and in general, the more protection from losses an option provides, the higher the premium. For instance, a put option with a strike price of $100 will cost more than one with a strike price of $90, because in the event of a substantial crash, the first option will give you $10 per share more in protection than the second. You'll also pay more for an option that gives you more time to exercise it than one that expires sooner.
Supply and demand also plays a role in the pricing of put options. Because most investors don't think about potential downside when the market is soaring, you can often buy put options cheaply then. The CBOE Volatility Index (VOLATILITYINDICES:^VIX), which is often called the Fear Index, is actually a measure of pricing of index options on the S&P 500 Index (SNPINDEX:^GSPC). Although it has perked up a bit in the past couple of weeks, it's still at extremely low levels. If you wait until a larger correction has actually taken place, then interest in put options for protection will jump, and you'll have missed your chance to get the best value.
The important thing to realize about put options is that you can lose every penny you spend on them. In some ways, you might actually want to suffer option losses. Just as you buy insurance for your home or car in the hopes that you'll never actually suffer a loss or accident that requires you to use it, put option strategies to protect the value of your portfolio don't change the fact that you'd prefer for your stocks simply to keep rising in value.
By letting you participate in further market gains while still offering some crash protection, put options can let you have your cake and eat it, too. The best time to think about puts is when no one else is, and it's important to beat the rush if you want the risk reduction that they can offer.