After posting gains in a portfolio, the last thing you want to do is give them back. Protecting your stock portfolio is an extremely important part of portfolio management. There are several ways to approach this; some of the most common include buying put options and buying inverse exchange traded fund (ETF). It is necessary to understand how each works and how well each achieves the goals of protecting portfolio gains.
Types of Protection and Making the Right Choice
The consideration to buy protection is typically due to a fear that something negative will happen in the short term which will impact your portfolio. First, it is important to identify why you are considering the purchase of protection: Are you expecting a short term correction in the market? Are you fearful negative news may impact a stock in the short run but long term fundamentals are strong?
Stock Specific Fears:
If you have stock specific fears, then purchasing put options to hedge against a stock’s decline is an appropriate action.
Buying a put option gives you the right but not the obligation to sell 100 shares of the underlying equity at the set strike price. Therefore if you are concerned about short term volatility you could purchase puts in the amount equal to the quantity of underlying security with a strike price equal to the minimum price you are willing to continue holding the stock and for the time frame you are concerned the volatility will occur.
For example, let's say you own 100 shares of stock XYZ, a pharmaceutical company, currently trading at $55. You think the long term prospects are favorable but are worried about some short term volatility over the next two months as some clinical data will be released. If the news is negative, then you are willing to hold the stock as it falls to a minimum of $50 (ignore the put premium in this case), but if it falls below that price, you are unwilling to hold it. Based on these parameters, you should purchase one put, which gives you the option to sell 100 shares (the amount you own) with an exercise date of two months and a strike price of $50. Therefore, if the stock falls but maintains a price greater than $50, you are willing to hold the stock and withstand the short term volatility. But if the stock falls below $50, the put with be exercised protecting you against losses below the $50 mark.
Industry or Market Specific Fears:
If you have fears that an industry or the broader market might experience some near term slow down, you have a few options. The first is achieved through buying a put on a sector or market ETF. Find an ETF that contains stocks that match your holdings in similar weights for a sector that in turn matches your holdings on a broad market basis. For example, if you are concerned that the pharmaceutical sector stocks in your portfolio will fall, you can purchase a protective put on a pharmaceutical ETF, like the SPDR S&P Pharmaceuticals ETF (ARCA:XPH). Similar to the previous example, you would strive to match the time frame, quantity and prices based on your expectations and levels you are willing to accept.
Alternatively, you can purchase an inverse ETF. The key to buying the appropriate inverse ETF, like any ETF, is researching the underlying holdings to match the names with the holdings in your current portfolio. Using another example, if you are fearful the market may experience a short term pullback, and you own many stocks held in the Dow Jones Industrial Average (DJIA) you can use an ETF, such as Short Dow 20 (NYSE:DOG), to hedge your exposure to the DJIA.
Another goal when buying protection may be to add it in a high enough quantity for the purpose of providing adequate time to unwind a position. This means you determine what percentage of the portfolio you would are willing to lose while you unwind a position and that dictates the amount of protection you purchase.
The Bottom Line
Despite the choice of security, understanding your goal is crucial to accomplishing it. Buying protective puts, short or leveraged ETFs are the most common tools and the choice depends on the reason for buying the protection as well as the degree of understanding or complexity of each investment.