One of the Best Ways to Protect Your Portfolio from Market Uncertainty

The fear is palpable.

The euro zone is on the verge of collapse. And the peripheral countries in the eurozone like Greece, Spain, Portugal, and Ireland are leading to the potential demise of Europe’s financial system. No matter the reason, if Greece defaults contagion will certainly occur and the U.S. markets will not be able to escape the catastrophe.

Yes, you will hear the talking heads speak about how the U.S. markets will not be affected by Greece, but no one knows for certain. To say otherwise would be irresponsible. Remember, these are the same people that were hyping the market literally days ahead of the financial crisis in 2008.

Investing is about managing risk. And it is up to you, the self-directed investor, to make the ultimate decision on how to properly manage your investments. No one cares more about your money than you. It amazes me why this is so often overlooked by investors and traders alike. They seek profits, yet they neglect to learn how to best keep them.

Hopefully I can give you a push in the right direction. I am not here to tell you what to invest in; rather, I want to teach you appropriate strategies.

For instance, if you are fearful of a sharp decline over the coming months, yet you want to keep your buy and hold portfolio intact, then I can teach you a few strategies that might soften the blow to your long-term portfolio.

Long-Term Protection for Your Portfolio Profits

Let’s say you own 100 shares of Wal-Mart (NYSE: WMT) and it is currently trading $10.00 above your original purchase price of $45.00. You want to continue holding the position, yet you are concerned that continued struggles in Europe could lead to WMT shares taking a tumble.

What is the best way to protect your gains over the long term?

In the past I have discussed the benefits of the collar option strategy (one of my favorite stock and portfolio hedging strategies) as a form of short- to intermediate-term protection, but in this case, for longer-term protection I would prefer to buy a protective LEAPS put.

Long-term Equity AnticiPation Securities (LEAPS) are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years.

Example: WMT is trading at $60.00. You are long 100 shares at $45.00 and want to hold WMT for the long term. You do not want to risk losing all of the $15.00 increase in share value, or $1500, and you are perfectly fine paying the cost of insurance if it means that you will be able to keep a portion of your current gains.

Outlook: Again, you are bullish on WMT over the very long term but nervous about unseen events over the next 3-18 months.

Strategy: LEAPS Protective Put – Buy 1 WMT January 2014 55 put for $5.00 or $500.

Stock Change     WMT     Long 55 Put         Stock P/(L)          Option Cost        Net P/(L)

+16.6%                 $70         $0.00                     $1,000                   ($500)                   $500

+8.3%                    $65         $0.00                     $500                       ($500)                   $0.00

0.0%                      $60         $0.00                     $0.00                     ($500)                   ($500)

-8.3%                     $55         $0.00                     ($500)                   ($500)                   ($1000)

-16.6%                  $50         $500                       ($1000)                 ($500)                   ($1000)

-25.0%                  $45         $1000                    ($1500)                 ($500)                   ($1000)

As you can see in the chart above the $500 cost of the WMT LEAPS options insures your stock position to a maximum loss of $1,000 with unlimited upside potential after the break-even point of WMT at $65, or 8.3%.

The maximum loss is based on the cost of the LEAPS protective put ($500) plus the out-of-the-money amount ($500) at the time of the established position. Basically, the most you can lose on WMT is -8.3%, or $1000, no matter how far the stock drops.

The stock could drop back to 2007 lows at $35 and your max loss would still be ($1000).

So, if you are fearful of a sharp push lower over the coming months due to the ongoing European woes and you want to protect some of your hard-earned long-term profits think about using LEAPS protective puts. It limits your downside while leaving the upside potential of the stock intact. 

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