Are you worried about the recent losses in the stock market? We haven’t had a week as bad as this since the 2008 Financial Crisis, and apparently it’s also the fastest 10% decline in history after the market just hit all time highs. If you’re investing in the stock market, you have a right to be worried, as the majority of investors out there have few means to protect themselves in case of large losses.
At Parabolic Asset Management, here’s how we’re able to invest and avoid the majority of the recent losses in the stock market to give our clients peace of mind. The key is to invest with protection.
How do we do that?
By using options strategies that limit our losses in case markets fall. “Put options” are a form of fire insurance for your investment portfolio, just like your fire insurance for your house. If your house gets burned, your insurance will make you whole. If you have put options and your portfolio gets burned, it will make your portfolio whole again and protect you from harm.
Now when you buy puts, it protects you from losses up to 100% from the starting reference point for the market. So for example, if the stock market was at $100, if you buy a put option with a starting reference point of $100, if the market falls to $0, you’re covered for losses all the way to $0. It’s an “all-you-can-eat strategy” and you’re paying for that assumption that markets can fall to $0. Now in reality, it’s highly unlikely that the market will fall to zero. The majority of the time, it goes up and down in a range of about 15% in any given year.
The options strategy we use assumes that the market could fall up to 15%, and that’s all we want to pay for. If it falls more than 15%, our belief is that prices are at more attractive levels, and we are willing to own the market when panic is in the air and fear levels are high, much like what we have today, since that tends to be a rough area where markets try to fight back from their losses.
Since put options are expensive, we want to reduce the cost of the protection as much as possible. So Step 1, we buy put options that protect us starting at the $100 reference point, and then Step 2, we sell put options that limit the loss protection up to 15% (or $15 in this case, at $85). There is still a net cost to buying this protection in case the market falls from $100 to $85. Now to make this cost go down even further, Step 3, we sell a “call option” that limits our upside gains to about 8.5% for the year. The proceeds from the sale of the call option help pay for the protection we get from the put options.
What we end up with is a portfolio that participates in the gains in the stock market up to 8.5%, and in exchange for that upside cap, we are given a parachute that protects us from losses up to 15% in case markets fall over a cliff. It’s an asymmetric payoff structure that is very attractive to us in this environment, and we were fortunate enough to implement this approach in February as markets reached new highs and sentiment levels became a bit frothy.
This graph below is a hypothetical illustration of what would have happened in 2007/2008 if you applied the above protections to a portfolio tracking the S&P 500 index. While the stock market was down by about 15% in the example below, the loss-protected approach had gone down temporarily (and by a lot less), but by the end of the investment period, it had zero losses.
This is how we protect our clients and give them peace of mind during turbulent times. Imagine not having to worry about losses up to 15% in the stock market and still being able to participate in potential gains. Are you ready to feel more secure about your financial future? If so, contact us today.
