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Here's How to Insure Your Portfolio Against a Market Decline

Losses are a part of success for investors. No stock goes up every day, and no investor has winners 100% of the time. Individual stocks and funds can move up or down on any day, but most investors find they make money when they own stocks in a bull market and they lose money in a bear market. Potential losses can be large. Twice since 2000, major stock market averages have fallen by 50% or more.

There are several strategies individual investors can use to protect themselves against big losses.

One method is to follow a simple moving average (MA) system. If SPDR S&P 500 (NYSE: SPY) closes below its 10-month MA, for example, the investor could decrease their exposure to the stock market. The chart below shows this strategy delivered timely sell signals in 2000 and 2008, and also signaled that it was time to get back into the market near the bottoms in both cases.

There were actually a total of 10 trades over the time shown in the chart, with most delivering small gains. Eight of the trades were winners; an investor following this strategy would have turned $10,000 into $25,078 over the past 17 years. A buy-and-hold investment in SPY would be worth $24,999, without dividends. While the gains would be about the same, the risk would be much lower with the 10-month MA. Investors never lost more than 12% with that timing tool, whereas buy-and-hold investors suffered losses of 50% in 2000 and 55% in 2009.

This simple strategy might be enough to ease the fears of most investors. But there are some investors who are nervous about a 1987-style crash when prices drop suddenly. For them, put options might be a strategy to consider.

When you buy a put option, you will make money if prices fall. The option specifies an exercise price and an expiration date which we'll show with a specific example.

With SPY trading close to $160, investors might be worried about a 20% decline that would push the price down to about $128. A put that expires in December can offer protection against a loss like that until December 21, close to the end of the year.

The cost of the put will be like an insurance premium. If the market suffers a big loss, the insurance will pay off, but if it doesn't, the premium paid for the policy will be a loss.

We can buy a December put on SPY with an exercise price of $149 for about $4.69. An options contract usually covers 100 shares of a stock or ETF, but for SPY and a few other high-priced investments, a mini-option is available that covers only 10 shares. The value of each contract is about the same. Buying the full-sized contract would cost about $475 while the mini would only cost $47.50.

A put option rises in value when prices fall. In this example, the $149 put gives you the right to sell 100 shares (or 10 shares in the case of the mini) at $149. If SPY were at $128, you could buy shares for $128 and immediately sell them at $149 for a guaranteed profit of $16.25 per share. The options market allows you to take the profit without having to buy the shares by simply selling the put to close the trade.

An investor with a $100,000 account could use the put options to offset the losses that would be suffered in a market crash. Using round numbers as an example, that trade would look like this:

-- Buy one SPY December 149 Put for $475
-- If SPY falls to $128, the profit would be $1,625
-- If the account falls as much as the market, the value would be about $80,000

A single options contract would offset a small portion of the losses but the account would still suffer a loss of more than 18%. If the market does not fall, the cost of the option will result in a loss of about 0.5%. It would take about 10 contracts to offset the losses fully and that requires accepting a loss of 5% if the market doesn't crash.

Comparing this to the 10-month MA shows that the simple strategy might be a better form of protection under most circumstances. With SPY near $160, the 10-month MA is at $149, about 7% below the market. The loss would be smaller with this strategy.

Of course markets can move quickly and you might not be able to get out at $149 if prices gap down at the open. The risk of a large gap is better to address with put option. Although portfolio insurance with options is possible, it can be expensive. Very nervous traders should consider some put options along with a sell strategy like the 10-month MA.

Plan now to protect your account value in a bear market. A simple market timing model like the 10-month MA or put options could be used to reduce risks.