A Little Insurance Wouldn't Hurt Now

 | Oct 10, 2013 | 2:30 PM EDT
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It's no surprise that Congress, or shall we say politics, moves markets, especially in the very short term. Publicize a political deadlock about the budget or the debt, and the market slides. Suspect that a resolution is in the works, and the Dow jumps 150 points. Apparently, the value of Procter & Gamble (PG) a multinational producer of detergent, razors and shampoos, is plus or minus several billion dollars, depending on what the political mood is on a given day.

A little portfolio protection here is not a bad idea. The most aggressive bet, one I don't recommend but which works handsomely if you are on the right side of the coin, is simply betting on volatility. When markets are steadily rising, volatility diminishes. When the market gets nervous, even for a couple of days, volatility spikes. The CBOE Market Volatility Index, usually known by its symbol VIX, illustrates how volatile volatility can be.

Consider the closing day prices for the VIX in the past several days:

  • Friday, Oct. 4: $16.74
  • Monday, Oct. 7: $19.41
  • Tuesday, Oct. 8: $20.34

As of this morning, the VIX is trading around $17.24. Generally speaking, the VIX climbs higher when markets are declining and heads lower when markets are climbing. But this type of insurance is very short term and requires a little luck in the timing, especially in this type of market environment when the market is gyrating up and down.

In the past five years, the stock market as soared well past its all-time high reached in October 2007. So equity prices are just not as attractive as they once were. While the Federal Reserve's current monetary policy puts equities on a pedestal, those policies won't last forever. And it looks like politics will continue to run into deadlocks for the foreseeable future.

So primarily because of valuation, and secondarily because of the other mitigating political and economic factors, insurance is a good thing. The simple purchase of put options on major portfolio holdings is a simple yet effective way to purchase insurance. The modest premiums incurred to obtain the insurance is likely more than made up by the significant gains that you presumably earned over the past year or more.

A more general insurance policy is to buy put options against the S&P 500 index, thereby providing blanket coverage against a general market decline. If your portfolio is one that looks like the general market -- dozens of securities with no significant concentrations -- then insurance against the general market is sensible. But if you have significant positions and hold a more concentrated portfolio of 30 stocks or fewer, it's more effective to own specific puts. Many individual stocks face declines that could be worse than those in the broader market.

Portfolio insurance is sensible, and you should consider it in this environment.

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