Rathbun: New highs, new hedgeWritten by Gary Rathbun | | GaryRathbun@PrivateWealthConsultants.com
Almost every day, the market is hitting new highs and with each new high, the market seems a little scarier. Some of us who study the psychology of individual investors in the market are starting to see uneasiness out there. People don’t want to get out for fear they will miss some more gain, yet they are concerned that the market will drop before they are able to get out and preserve their value.
What to do?
There are several ways to hedge a portfolio and minimize the effect of a market decline. Probably the most popular method of minimizing the effects of a downturn in the market is through the use of stop limits or trailing stops. To use these tools, program a computer to automatically sell your holding once it reaches a specific price. For example, if you owned Microsoft stock and it is trading at $34 a share, you can set a stop limit for $32.50 and if Microsoft shares reach this price, an automatic sell order will be placed to sell your shares.
A trailing stop is similar but it is usually set at a percentage of the share price rather than a specific price. You could set your trailing stop at 5 percent of the current price and if the stock went down 5 percent, i.e., $32.30, then a sale would be triggered.
As the stock moves up, the trailing stop follows at the same percentage. If the stock moved to $35, your trailing stop would automatically move to $33.25. The stops never move down unless you move them manually.
A little more sophisticated method of hedging is the use of put options. Keeping with the Microsoft example, suppose you wanted to make sure you received at least $33 a share between now and July. You could simply purchase a put option which obligates the seller of the option to pay you $34 a share regardless of the market price of the stock. If the price of Microsoft went to $20, you would still be able to sell your shares for $34.
A put option is kind of like an insurance policy against the share price going down for a specific period of time. Like any other insurance policy there is a cost to this put. The cost might be 45 cents a share for the time frame we are talking about. If the stock drops, the price is very cheap and if the shares stay above $34, you purchased the insurance and didn’t need it. The further out you go with the put option, the more expensive it will become, since you are buying time as well as price protection.
An even more sophisticated method of hedging is called an equity collar. With this method you purchase a put option but you also sell a call against your holding as well. In essence, you “collar” the stock between two separate prices. For Microsoft shares, we may buy a put at $32.50 and sell a call at $37.50. With the stock currently around $34 or so, this effectively collars the stock between these two prices. Either you will get $32.50 if the stock falls $37.50 if the stock increases or keep the stock if it stays between the two prices.
Any of the above is worth looking at with your adviser, especially if you think your holdings are at risk of going down or you want to lock in gains.
Gary L. Rathbun is the president and CEO of Private Wealth Consultants, LTD. He can be heard every day on 1370 WSPD at 4:06 p.m. on “After the Bell,” every day on the Afternoon Drive, and every Tuesday, Wednesday and Thursday evening at 6 throughout Northern Ohio on “Eye on Your Money.” He can be reached at (419) 842-0334 or email him at email@example.com.