Current Bull Market Stresses Importance of Protective Puts

By Kevin Dixon, Market Traders Institute

As the saying goes, the trend is your friend and 2015 has continued to drive the current bull market trend to record levels as the Standard & Poor’s 500 index (SPY), Dow Jones industrial average (DIA), Russell 2000 (IWM) and NASDAQ 100 have all closed at new all-time highs heading into the last week of February. The NASDAQ Composite is now within striking distance of setting new all-time highs that compete with previous levels established during the “Tech Bubble.”

With all this bullishness, where are the bears?

While the truth remains that there are no catalysts to stop the current trend from pushing our price levels higher, there is always the looming fear of change. In this context I offer some food for thought: protect your profits.

The simplest method for protecting your portfolio from sudden change is to add protection to a long position by purchasing a long put option, also known as a protective put.

A protective put is a risk management strategy that functions as a type of insurance should stock values decline.

The put can provide income versus a temporary decline in the stock over the amount of time purchased, or in fact become a primary trade should the trend change from bullish to bearish. This could allow the investor to potentially profit from short-term moves against their long position which can further reduce your cost basis, or be used as part of an exit strategy to shift the portfolio’s direction from bullish to bearish.

The key term here is protection. Since this strategy involves the purchase of an offsetting asset, it is adding money to the existing trade. Remember, the rule says not to risk adding additional money to a losing trade. A losing trade is a losing trade, with or without a put.

There are many different ways one can consider timing the entry of a protective trade. Let’s review some examples of when we might consider adding protection:

1. Key Resistance- As we approach key resistance areas, the stock price will often slow down and pullback. You could create a quick, low-risk trade by buying a long put in-the-money position and placing a stop just above the resistance area. I prefer a minimum of 90 days while being 10 percent in the money. A solid delta is key to taking a quick profit while maintaining your long-term view on the stock.
2. Moving Average Crossovers- When the 50-day Exponential Moving Average (EMA) crosses below the 200-day EMA, the bearish move has been seen to attract new sellers. Placing a long put trade in this example could lead to buying more time later as a new trend develops. By placing a tight stop loss slightly above the 50-day EMA and buying in for at least 90 days with 10 percent in-the-money, you could profit faster from this potential trend change. Should the trend actually reverse, you will have placed your trade at the front of the move.
3. News Momentum- Anytime I am profiting before a significant corporate event, I consider buying a put for a quick insurance policy to protect my current profits. In using this method, you are protecting against an earnings report, I consider buying a front month put, but generally 30 to 60 days is ideal for earnings protection. Many traders would consider trading out of-the-money in this instance, but that is not truly protecting your position. An in-the-money put will serve the purpose of offsetting a negative move against your base position. Look for a delta of -0.70 to -0.85 range with open interest above 300.
4. True Trend Change Develops- When your technical indicators (such as Fibonacci or a time interval) change, it could mean that the market is preparing to move in the other direction. If working off a daily time frame or smaller, I would allow at least 90 days in-the-money and invest at a delta of 0.70 of better. This is a potential reversal pattern, so consider buying more time ­-- 180 days or leaps.
5. Overly Invested in One Stock- When you have placed more than 3 percent of your trading account in any one position, you are considered over-leveraged in that trade. A great offset to being overly invested in one position is to buy the other side on dips using long puts, reducing your cost over time.

Another way to protect your portfolio is to consider using exchange-traded funds (ETF) as a hedge to the markets themselves. Index tracking ETFs such as the DIA, SPY, PowerShares QQQ Trust and IWM could be used as a protective put versus the stock market. Hedging allows you to choose the ETF that matches your risk portfolio instead of purchasing several different protective puts, giving you a broad layer of market protection.

With so many classes of ETFs in various sectors, I could strategically purchase protection across markets. An example is: If a trader owns Bank of America and Travelers Companies, the Financial Select Sector (Financial SPYders) could be a great addition for protection.

While the concept of protective puts and hedging have been in the markets for many years, timing is key. A solid plan for change could help you make money on both sides of a trade and insure that you are able to maximize your profits and reduce the potential for maximum loss.