I often talk about the important of buying index puts to protect your portfolio from downside action. Inevitably, I am asked how much put protection is actually needed. It’s a fair question. Just like with homeowner’s or life insurance, you don’t want to buy more (or less) than you’ll actually need.
Why you need put protection
But first, let’s talk about why you need it. Whether the stock market is in a bullish or bearish trend, it can pull back at anytime. The pullback can be short or long, and the variables can change constantly. I don’t know about you, but I like to sleep at night and I’d rather know that my portfolio is protected from a sharp market drop.
Maybe you’ve noticed that stocks rise slowly but fall quickly. This can be explained by the wall of worry principle. Climbing higher requires a more cautious and guarded approach. When the markets are falling though, everyone rushes for the exit. When will everyone rush for the exit? No one knows (and if you hear someone say they do know, they’re guessing at best, lying at worst).
How much put protection you need
When using put options as your protective vehicle, buy the equivalent of 2-5% of your total invested capital. That is enough to protect against a drop in the markets.
Here is an example: Let’s say you have $100K of capital working in your trading/investing account. You currently have $70K invested in positions; the other $30K is in cash. You only need to protect the $70K, so a 3% allocation towards option puts means you need to buy around $2,100 worth of puts. I suggest you spread around your puts. Look at the charts and find the weakest index. Generally, I find the SPY, QQQ, DIA and IWM have the best liquidity.
That amount is not fixed, by the way. You might drop down to $1K or climb higher to $3K depending on the current environment. If the markets are wildly overbought, you want to add more protection.
Lastly, if the puts happen to rise in value, sell some puts, bank some profits, and maybe roll down to a lower strike to keep that protection on. There is no better feeling than banking a winner when the markets are falling!
