Thanks to billions of dollars in quantitative easing from the U.S. Federal Reserve, fears over a looming stock market crash have been put on hold lately.
The Standard & Poor's 500 Index is up 16% this year. The market's outstanding performance has shrugged off weak earnings reports, slowing growth in China, and continued weakness in Europe.
It seems that zero interest rates really do trump all. Even Warren Buffett is unsure how all this ends, telling shareholders at the Berkshire Hathaway (NYSE: BRK.A, BRK.B) annual meeting "it's really uncharted territory. It's a lot easier to buy things sometimes than it is to sell them."
And I recently heard legendary real estate investors who at a conference compared the market to a game of musical chairs where everyone keeps playing because the music – QE – is still going.
But they cautioned that investors who aren't careful will be quickly left without a seat.
That's why investors should take steps to protect their portfolio from a possible severe decline in prices. Whether it's a stock market crash or a more mild price pullback, you always want to make sure you're prepared.
How to Protect Your Profits from a Stock Market Crash
It's time to sit down and go through your holdings stock by stock and ask some key questions:
- Is the reason you bought the stock still true?
- Do you have stocks that have experienced strong gains and now sell at very high valuation based on earnings, sales, and asset value?
- Has the company's business or financial position changed for the worse since you bought the shares?
- Would you buy the stock again today at the current price?
This type of prudent pruning can help you accomplish two things that will help protect you against losses from a market crash or sell off.
First, getting rid of overvalued stocks and underperforming companies will reduce your overall exposure to the market. Increasing your cash holdings may lower your return in the short term, but cash does not decline in a sell off.
It also gives you dry powder in your arsenal that can be used to scoop up bargain issues after a steep decline.
If you want more protection than pruning provides, you can buy insurance against the decline; here's one way to do that…
Using put options on the S&P 500 Spyder Exchange Traded Fund (NYSE: SPY) gives you "stock market crash insurance." You can even pick your own deductible based on how much risk you feel you can endure.
If you are worried about a decline in the market of more than 10% or so, you can buy a put option at $150 on the SPY that expires in January 2014. Each contract will cost you about $378 or about 2% of face value. If the SPY falls below 150, the puts will rise in value protecting you against steep losses.
Each contract represents roughly $16,000 of market value right now so you will need seven contracts for every $100,000 of portfolio value for full protection. If you want a longer term insurance policy, you can buy the same option for about $676, or 4.5% of face value that expires next June.
If you prefer more protection, you can protect against a loss of greater than 5% by purchasing options with a strike price of $157. This will cost about $550 for each January contract.
Just like all insurance policies you buy, the more protection you want, the higher premiums you pay for coverage. If the stock market falls you will enjoy the offsetting gains in the put options to keep your portfolio value relatively steady.
Of course if it does not, you lose the premiums paid just as you do with auto or homeowners insurance.
For more ways to keep your portfolio protected from a stock market crash, check out what our Private Briefing investment service members have been using…
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