Use Options to Protect Against the Next Market Crash

Stocks have had a great run in the last few years: most folks don’t realize it, but since the market bottomed back in March 2009, the S&P 500 index has rallied more than 115%.

Yes, in just a four-year span, the biggest stocks in the world have more than doubled…

Just think about that for a second.

Despite the recent correction, we’re still in one of the biggest stock rallies in history.

And in fact, the big market indexes have even managed to hit new all-time highs this quarter. Generally speaking, stocks have never been worth more than they’re worth right now. As investors start to get confident in the stock market again, there’s an important question worth asking:

What are you going to do when the next big market crash comes?

Just to be clear, I’ve made it no secret that I’ve been quite bullish for a while now. And obviously, I’ve been right for a while too. But good investors don’t operate without a contingency plan — and options can provide you with one.

Today, I’ll show you how you can use a plain, simple options strategy to protect your portfolio against the next crash.

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. But put options have a lot to offer as well.

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.

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 sell that two-buck asset for the full $5. You can see why that’s a good thing…

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 — even if a spaceship smashes into it while you’re out of town. 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.

So, if put options are like insurance, you can use them to protect your whole portfolio.

For instance, you can buy a put option on a market ETF — like the PowerShares QQQ Trust (NASDAQ:QQQ), which tracks the Nasdaq-100 Index — and get paid out when the stock market drops!

(Since the Nasdaq-100 is a little more volatile than, say, the S&P 500, we’ll use that as our example. After all, our put will pay out more with an index that takes a bigger hit!)

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”…

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 know that would work with out QQQ example…

As of this writing, QQQ trades for around $73 per share. Let’s say we want our “insurance policy” to kick in if the index crashes — in that case, we could buy the QQQ $50 January 2015 put. That put gives us the right to sell the ETF for $50 per share anytime between now and January 2015. (In the real world, we’d use a little more analysis to pick our strike price and expiration, but this put will get the point across.)

That option currently costs $1.25, which means a total investment of $125 for a contract ($1.25 per share times 100 shares in a contract). That $125 cost is what you’re paying to insure your portfolio…

Here’s what the profit and loss graph looks like for that put option:

If the market crashes, and QQQ falls through $50, your insurance policy starts paying out.

In the graph above, you can see how you’re out a flat $125 if QQQ stays above $50. But if the market does crash, and QQQ falls through $50, your insurance policy starts paying out:

  • If QQQ hits $48.75, you’re at breakeven for the trade (you’ve made enough to cover the premium)…
  • If QQQ falls to $45, you’re sitting on gains of $375…
  • And if QQQ drops all the way to $25 (like it did in 2008), you’re up a whopping $2,375

I should note that your gains could actually be much bigger than that. Remember, the graph above only shows your profit from the put option’s intrinsic value. If QQQ crashes with enough time until expiration, this option’s time value could get huge — and you could sell your option well before expiration for a big profit.

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

If you do use it, then it helps to offset the losses in the rest of your portfolio…

Happy trading,

Jonas Elmerraji, CMT

The Daily Reckoning