The Fireworks are just getting started in the Stock Markets

I hope everyone had a safe and happy 4th of July!

The US Stock market sure has had a lot of fireworks over the last 7 years. Stocks have had a great run since 2009, but like all good things, at some point it has to come to an end.

In a seven year span, the S&P index is up roughly 200%. Despite the recent correction after the Brexit vote, we’re still in one of the biggest stock rallies in history. Generally speaking though, stocks have never been worth more than they’re worth right now. Price earnings ratios and Price to sales ratios are at an extreme highs making stocks very expensive.

What can you do if this bull market is ending?

Just to be clear, I’ve made it no secret that I’ve been expecting 2016 to be a bad year for the markets. I have said that we could see possibly a 40% correction, taking the S&P to the 1250 area. Today, I’ll show you how you can use a plain, simple options strategy to protect your portfolio against the next crash.

How? By Buying Put Options.

Most investors who are new to the options world are most familiar with call options. Calls are popular because buying them is a lot like buying a stock, only with a ramped up reward-to-risk ratio. When the stock goes up, call options go up a lot. Put options offer the same reward profile but makes money when the stock or index goes down in value. As many of you know, it takes a while for stocks to go up, but they can come down rapidly.

As a refresher, buying a put option gives you the right (but not the obligation) to sell a specific stock at a specific strike price and by a predetermined expiration date. What does that accomplish exactly?

Basically, buying a put lets you bet against a stock or an index like the S&P 500.

Let’s say that our imaginary example XYZ Corporation has shares of its stock currently trading for $5. But this time, you think that the stock is overpriced and it’s headed lower in the next couple of months — so you buy an XYZ Corp. $5 June put option. Your put option gives you the right to “sell shares” of XYZ for $5 anytime between now and June’s options expiration date (the date isn’t important in this example).

So, if you’re right, and XYZ falls down to $2, your puts give you the ability to make $3. Sell it for $5 and buy it back for $2.

In every other way, buying puts works just like buying calls: your risk is limited to the cost of the options (because if XYZ’s price rises above $5, you wouldn’t bother with it), and the cost of the options is determined by intrinsic value and time value.

With puts, intrinsic value is found by subtracting the option’s strike price from the stock’s current price.

In a big way, put options are a lot like insurance.

When you buy a $200,000 homeowner’s insurance policy for your house, you’re saying that you want to be able to get $200,000 for your home if a catastrophe takes place. With our XYZ put example, you’re saying that you want to be able to get $5 for shares of XYZ — even if some catastrophe destroys shares’ value.

For instance, you can buy a put option on a market S&P 500 and get paid out when the stock market drops!

Insuring Against a Crash

To insure against a crash, you need to buy a put option with two characteristics: it’s got to be cheap, and it’s got to have plenty of time to play out.

The best way to do that in one step is by buying a long-term put that’s way “out of the money.” Out of the money options have zero intrinsic value. Think of these options as betting on a long shot in a horse race.

Remember, you want to minimize the cost of your portfolio’s “insurance policy”. That cost has two factors: time value and intrinsic value. We need plenty of time on our “insurance policy” — so unfortunately, our time value is going to cost more. To make up for that higher time value, we’ll use a put option that has zero intrinsic value. That way, our insurance policy only pays out on a really big move down, but it’s cheap to buy.

So, let me show you how that would work if the Stock Market does crash!

As of this writing (early July 2016), the S&P trades for around $2085 per share. Let’s say we want our “insurance policy” to kick in if the index crashes, we could buy the SPX $1350 December 2016 put. That put gives us the right to sell the SPX for $1350 per share anytime between now and December 2016.

That option currently costs $4.75, which means a total investment of $475 for a contract ($4.75 per share time’s 100 shares in a contract).

If the market crashes, and SPX falls through $1350, your insurance policy starts paying out.

During the recent Brexit market fall, this option doubled in value. If the SPX does go down to $1250, your $4.75 option will be worth a minimum of $100!

Just like a regular insurance policy, if you don’t use it you’re only out what you paid for your premiums or $4.75.

The Stock market tends to go in cycles. Remember the internet bubble of 2000? How about the crash in 2008? Hmm every 8 years…. That would make 2016 a year to go down. The question you have to ask yourself is… is it worth a chance to invest $4.75 to make $100? I’ll take my chances!

Remember to Plan your Trade and Trade your Plan