#4: Buy Puts or Sell Calls
This is the truest hedge of the investment options I’ve laid out.
Buying a put is the closet equivalent to actual portfolio insurance you will ever find. In an insurance arrangement — be it home, auto, health or life — you pay regular premiums. The insurance policy is an expense that costs you money — unless a catastrophic event happens, and the policy pays off.
The logic behind a put is the same. If you buy an out-of-the-money put on the S&P 500 and the market rises or trades sideways, then your option expires worthless — the same way that fire insurance is “worthless” unless your house burns down. But if the market falls below the strike price of the option, the option pays off.
If puts are such a great insurance policy, then why doesn’t everyone use them? The answer is simple: They are expensive. As an example, a put option to sell the SPDR S&P 500 ETF (SPY) on or before Feb. 7 for $180 per share (slightly below the current price) will cost you $1.19 (so, $119 for a contract for 100 shares). That’s just fine if you really believe a selloff is coming. But if not, it’s throwing money down the drain.
But if you think any correction is likely to be mild, there is an alternative. You can sell a covered call option. In a covered call, you sell the option to buy a stock you currently own to another investor and pocket the premium. If the option expires worthless, the premium is yours to keep as income.
The downside? If the value of the underlying stock rises, you will be forced to sell your stock at below-market rates. Of course, you would always be free to buy it back later.
Options trading is not for everyone. Of the hedging options I’ve mentioned, options are the riskiest for the uninitiated. If you decide to go this route, you probably should have your broker or financial adviser walk you through it the first few times.