7 ways to protect against market turmoil
Summary: After the stock market peaked at the end of last year, it has now taken a sharp turn South. Not only does rising inflation and the imminent interest rate increases have a negative impact on the market, but now there’s a conflict as well. The long-term effects are not yet clear but the impact on energy prices is already visible. Also, this action obviously does not contribute to geopolitical stability in general.
In any case, it leads to uncertainty and that’s something investors do not like. And it is precisely this uncertainty that is causing prices to fluctuate sharply.
How to deal with this? Of course, this depends entirely on your vision. If you think it is temporary and heavily exaggerated, then you do not need to move. If you think it could fall much further, it is important to take action. In this article you will find a number of possibilities.
It goes without saying that you should only apply the possibilities below if you are confident that the share/index/theme will rise (in time). If you are convinced that the stock will drop and will be lower in the coming years, you should sell ruthlessly. In addition, these strategies are only suitable for advanced investors who know well how options work.
Strategy 1: Cash is king
Take a broad look at your total portfolio and forget about the original purchase price. Actually, look at your total net worth because your overall capital value should be leading. And be aware, selling a particular stock will not affect your total capital, except for transaction costs. You can see your total capital as the summary of your portfolio at the highest aggregation level. With this approach, you rise above the level of your individual current holdings and this insight can help you to make the changes you want.
Look at your portfolio in the following way: if you had the value of your current portfolio in cash and you were going to invest, would your portfolio look exactly like this? If you are completely satisfied, no action is needed. If you are not, make the changes that will heighten your comfort level. And the easiest way to do this is to turn your equity holdings into cash. Do you prefer to lower the risk of the portfolio by 50%? Then halve your position.
Strategy 2: Exchange shares for long-term calls
What is the benefit of this strategy? You know that when you buy a call, you must pay a premium. But this is also your maximum loss! If you buy a share at € 15, then you can lose € 15. You can also choose to buy a long-term call that is in the money. For example, the call with a time to maturity of 2 years and a strike price of 12 (you have the right to buy the shares for € 12 for the coming two years) will cost (depending on the volatility) €4. This €4 is your maximum loss. If the stock drops from €15 to €7.50 and you own the shares, you will lose €7.50. The bought call option will also decrease in value of course and maybe it will only be worth € 1,25. You will make a loss, but this is much less than the €7.50 you would have lost in the shares. And if the stock price rises, you will benefit via the long call.
Strategy 3: Sell a portion of your shares and write puts
Imagine, you own 1,000 shares that are now worth €20. While you have confidence in the company, you also see that the stock falls when the whole market falls. And you see some dark clouds for the market in general. What you can now consider is to sell half the shares and at the same time write 5 put options (sell 5 put options) below the current stock price. If the stock goes up, you will earn from the 500 shares you still own. You can also label the received option premium as a profit because they will expire worthless. So, you're doing a good job when the market rises again. However, if the stock drops further, you will be obliged to buy the shares at the exercise price of the put option you sold. But this means that you buy the sold shares back at a lower level than the original sell price. You have, as it were, skipped a part of the decline.
Strategy 4: Write a call on stocks in your portfolio
If you write a call, you enter an obligation to deliver. For a lot of investors this feels annoying because this hinders the upside potential. The question is whether this is really the case. Assume a share is trading at €10 and the call with strike price 11 that quotes € 1. If you write this call (one call per 100 shares you own), you have built up a buffer of € 1 for a decrease in that stock. That is not enough if the share loses 50%, but it is better than nothing. And if the stock goes up, you can do two things. The first option is to do nothing and then deliver at € 11 (effectively at € 12 because of the € 1 option premium received).
If you don't want to deliver the underlying shares, you can roll the written call to a higher strike price. The time to do this is when the written call is At The Money. For example, if the price has risen to €10,95, it's time to think about rolling the written call. The reason to do it when the call is At The Money, is that you will be able to do it with a credit. You roll the C 11 to a C 12 with a longer time to maturity. By rolling when the stock trades around the exercise price, you will have to pay less for buying back the call than you receive for the call you will sell. You can repeat this rolling if it fits within your vision.
Strategy 5: Protect your shares by buying put options
A lot of investors know the way put options work. By buying a put you get the right to sell the underlying for the strike price until expiration of the option. At the same time, a lot of investors find puts too expensive. An At The Money put option could easily cost 8% - 10% (of the underlying) and in a high volatility environment this percentage could be even higher. So, buying puts can protect your shares, but it’s an expensive solution. A slightly cheaper possibility is buying a put spread instead of an individual put. The investment is smaller, but the protection is also limited.
One way to solve the high price for protection is a combination of strategy 4 and 5: the collar.
Strategy 6: Protect your stock investment with a collar position
In this strategy, you write an Out Of The Money call and buy a put option from the proceeds. This means that you enter into an obligation to deliver a higher level (written call) but at the same time you have the right to sell the underlying at the strike price of the put option (bought put). You limit your upside potential but also your downside risk. This is an appropriate construction for investors who want to reduce their risk.
Strategy 7: Write both call and put options
This is a combination of strategy 3 and 4. Assume the starting position is long 1,000 shares without any options. What you can do is to sell 500 shares (half of your position), write at the same time 5 puts with a lower strike price and sell five calls at a higher strike price. The option premium you receive for both calls and puts is a buffer for a moderate decline in the share price. And again, if you are not bullish on the stock in the long-term and afraid the share prices may really plummet, sell all your shares.
If you apply this strategy, you have entered into the following position: long half of the shares you originally owned, an obligation to buy at a lower level than the current price and an obligation to deliver at a price higher than the actual price of the shares.
If the stock falls, you will be required to buy 500 shares at a significantly lower level than at which you sold them. And if the stock goes up, you either roll the written call as discussed in strategy 4 or you deliver the shares at the strike price of the call option you sold.
Remember, stick to your size (especially in naked put option writing)
If you follow the strategy of selling naked puts in order to receive the premium and without the desire to actually buy the underlying shares, make sure you keep your size in check. Too often, investors only look at the margin obligation that writing options entails. They forget to look at the actual risk involved. If the share is €10, the margin obligation of a naked short put might be € 150. This may lead to investors selling too many puts because they can easily comply with the margin needed to do so. Nothing to worry about if the stock remains stable or rises. But in a falling stock market, this strategy can cause a lot of misery. When a market really heads south, only then does the real exposure become clear. So, stick to your size, especially if you write puts. Do not look at the margin, look at the underlying exposure.
In short, options offer sufficient opportunities to consolidate a profit. But before you apply any of the above strategies, make sure you understand them completely. To learn more, take a look at this article.
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.