As some mid-size regional banks continue to teeter, this is a good time to discuss how to to protect your portfolio against a stock market crash. Not that one’s coming! But it’s always better to be safe than sorry – especially when it comes to money.
First, it’s important to point out that markets generally go up over time. Look at the long-term charts (the last 100 years) of the SPX 500, Dow Industrials, or other indexes, and this proves to be correct.
Yes, there have been severe dips in the markets when investors were scared of losing all their money. But again, if you look to history as your guide, you’ll see that the dip buyers came in and picked up the markets – every single time.
So, why do you need to protect your positions if the markets always recover? Because you never know when the next dip will be so severe that markets will take years to recover. In fact, it’s normal for the markets to have a long period of recovery from sharp losses.
After the crash of 1929, it took markets several years to bounce back. Remember the global recession that hit in 2008 – 09? The SPX 500 fell to levels it had not seen since 1996. More recently, the COVID-19 pandemic caused markets to fall about 34% in a few weeks. In this case, though, they quickly rebounded. (Of course, the large amount of liquidity the Federal Reserve pumped into the economy restored investor confidence in 2009 and 2020.)
When markets drop, panic sets in. Do you sell everything before the markets drop to zero?
Those who use options to protect their portfolio against a stock market crash probably had less stress during these difficult times. How did they do it? I have two easy strategies for you.
How to protect your portfolio against a stock market crash
Let’s say you have owned 500 shares of Apple for some time, and you are worried about wobbly market conditions. After a strong run by Apple, the stock could dip with the rest of the market. A drop of 10 points in the stock means a $5,000 loss if you don’t sell the shares. You don’t want to sell, so you use covered calls to protect your portfolio instead.
Your Apple stock is worth $160 per share. By selling five calls against your stock that are well above the current price, you can pull in some nice cash. Perhaps in three to four months, could sell the 175 calls against your stock and cash in the premium. If Apple never gets to $175, you pocket the premium when the option contract expires.
This exercise can be repeated over and over again. If Apple goes down, you keep repeating the process, perhaps with even lower strikes.
Of course, this not a strategy without risk. If Apple rises up past the 175 strike, your stock can be called away. You would still have gains from today’s price of 160 up to the strike price, and you keep the premium of the option. You would not participate in gains above that strike price, but that’s OK. (Further, if your stock is called away it could create a tax liability situation.)
A second strategy for protection against volatile periods is to simply buy index put options. Put options rise in value when stocks or the market go down.
I use this strategy frequently during bear market periods, fewer times during bull markets. Big institutions (like hedge funds) also buy put options for downside protection.
My go-to index puts are SPY, DIA, QQQ, and IWM. I generally advise traders to have 3-5% of your portfolio invested in index puts. Though it will drag down your total return, it’ll greatly reduce the overall volatility of your portfolio.
Having some put options working, especially when they are cheap, will give you peace of mind that your portfolio can handle big swings. Remember, stocks moves down much faster than they move up, so only a few put options working can be an effective strategy to blunt large moves downward.