There is never a shortage of bears saying the stock market is overvalued and a crash in imminent.
The problem is that the market IS overvalued, and there are numerous macro issues that suggest that things are going to get worse before they get better. That’s why you may want to consider buying puts.
Right now, the market is priced at a price-to-earnings ratio north of 20 while year-over-year earnings are expected to decline about 5%. If you subscribe to the notion that stock prices follow earnings, well, there is no way that the market is delivering earnings growth of 20%.
What growth it is delivering is being financially engineered by buybacks. That’s the reason for puts.
As a proponent of owning a long-term diversified portfolio, I’m not crazy about hedging your market position by purchasing puts. However, some investors want these suggestions.
Protection Puts: SPDR S&P 500 ETF (SPY)
The most basic place to start in regards to puts is to buy them for the exchange-traded fund SPDR S&P 500 ETF (SPY). Since the S&P 500 is a primary benchmark and many investors default to this ETF as a proxy for owning the broad market, you could purchase puts on the index as a hedge.
SPY closed at $217 on Wednesday. Personally, I’m not concerned about a 10%-20% correction. That comes with the territory. If you are going to purchase puts, you are looking to hedge against a crash, and for a good long period of time. So first, I would look to purchase something with a strike price at $200 or below.
You could buy the Dec 16 $200 puts for a mere $3.65. So if the SPY falls below $196.35, you will start to make money as a hedge in a crash.
You could buy enough puts to completely offset any loss, but that could add up very quickly.
Protection Puts: PowerShares QQQ ETF (QQQ)
The PowerShares QQQ ETF (QQQ) is a fund that holds the largest 100 stocks in the Nasdaq.
QQQ has a history of volatility, due in large part to the large-cap tech stocks it owns, including the FANG stocks.
Many investors own the QQQ in addition to SPY, which I regard as a mistake since both are market-cap weighted, and have the same familiar names in each. Thus, they are doubling up on many names.
I would frankly ditch one or the other. If you ditch the SPY, or even if you decide to hold both, you can again buy out-of-the-money puts for very cheap. QQQ closed Wednesday at $113.44.
Again setting aside a 10% correction as not being worthy of panic, you could buy the Dec 16 $102 puts for only $1.75 per contract. That’s spending 1.7% to defend your portfolio against losses greater than 10% in the next five months.
Protection Puts: iShares Russell 2000 (IWM)
The next broadest, and next most popular, ETF is the iShares Russell 2000 (IWM). This fund holds the smallest 2,000 stocks in the Russell 3000 index, so it’s mostly small-cap stocks.
These stocks can also exhibit a lot of volatility in a crash. People rush to sell everything, but they climb back into large-cap stocks first. IWM closed at about $120 on Wednesday.
Once again, on the theory that a 10% correction is not a reason to panic, you could buy the Dec 16 $108 puts for $2.22. That’s more expensive than the other ETFs, but that’s because there’s more volatility. You are spending 2.1% to protect the portfolio on a decline of 10% or more.
Maybe you want to keep the cost down and truly protect against a crash. The Dec 16 $100 puts cost $1.23.
As of this writing, Lawrence Meyers has no position in any securities mentioned.
