With the stock market up 79% over the past 13 months and the economy still showing signs of strengthening, the last thing on investors' minds is the need for downside protection. That's why this might be a good time to put some low-cost insurance in your portfolio. If you wait until there's more evidence that you need the protection, you'll likely pay much more for it.
Civil fraud charges against Goldman Sachs (GS) by the U.S. Securities & Exchange Commission knocked the Standard & Poor's 500-stock index lower by as much as 2% on Apr. 16 and spurred a 24% spike in the VIX—a measure of the implied volatility of the index—to an intraday high of 19.70, from the prior day's close of 15.89. That's just the sort of unanticipated external event that serves as a reminder of the value of this kind of protection.
Barclays Wealth, the wealth-management division of Barclays (BCS), believes U.S. stock prices are still cheap, with room for further expansion in the second quarter, though at a slightly slower pace than in recent quarters. But Barclays warns that the economy could retreat if the Federal Reserve's first rate hike—likely to come in the fourth quarter of 2010—sends government bond yields sharply higher, or if fiscal tightening puts a bigger damper on consumer and investor confidence than expected.
Aaron Gurwitz, head of global investment strategy at Barclays Wealth, is fairly optimistic that the global economic recovery will stay on track. He sees stocks as the best asset to be investing in for the rest of this year but says the possibility that the recovery will falter, creating a prolonged period of economic pain and worse equity returns, merits worry. "Because interest rates are already at zero and fiscal spending is [maxed out], if we have another downturn, we're starting from the bottom of a deep hole without a ladder," he says.
To protect against a further big loss in clients' equity portfolios, Gurwitz has recommended they include put options on a broad equity index such as the S&P 500. He suggests buying a December put contract on the S&P 500 at a 1000 strike level. This would give the buyer the right, but not the obligation, to sell 100 units of the index at 1000 if it were to fall below that level before the contract expires on the third Friday of December, which comes on Dec. 17.
How many put options you buy should reflect how concerned you are about a major correction and what portion of your total equity exposure you want to insure, says Gurwitz. One put contract protects 100 units of the underlying index, or 100 shares of an individual stock. With the S&P 500 index trading near 1,200, one put represents almost $120,000 of insurance value, assuming the stocks in your portfolio closely mimic the index. The strike price you choose for the option you buy depends on how big a deductible you're willing to pay before having the right to sell the underlying index. With the S&P 500 around 1,200, buying a put that would be exercised when the index hits the 1,000 level means you're willing to absorb a loss of 200 points, or 17.3%, in your equity position.
Other choices than the December contract at the 1000 strike level might be a put at a higher strike level or one that expires sooner, says Gurwitz.
It's now much cheaper to buy portfolio insurance than it has been in a long time, especially with the market's year-plus rally, says David Fisher, chief executive of optionsXpress (OXPS), a trading Web site based in Chicago. The main reason is that the VIX is in now in the upper teens, even after the Apr. 16 Goldman-inspired market selloff—compared with a long-term average in the low 20s, he says.
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