From the November 01, 2012 issue of Futures Magazine • Subscribe!

Protect a diverse portfolio using a cashless collar

Options Strategy

Question:  How can you protect a diverse portfolio without going broke?

Answer:  Execute a cashless collar.

What would you think about someone who owned an expensive home but refused to insure it? This rarely happens because banks are not naïve and will not provide a home loan unless a person has proof of insurance. Yet, most investors in the stock market do not insure perhaps their single largest asset — their stock portfolios and retirement accounts. 

What happens if there is another surprise economic downturn like we had in 2008, which took the Dow Jones Industrial Average from 14,000 to under 7,000? You would feel as though your uninsured home was burning down and the fire department was not answering the phone. The facts are even scarier. You would be very hard pressed to find someone whose home burned down, but almost everyone suffered significant losses in 2008. 

For most, the reason for not insuring their future and security is one of three things: Ignorance, laziness or greed. This trilogy of character defects need not afflict you. You will see that, not only is hedging a portfolio easy, but it actually can increase your profitability over the long run. How do you think Warren Buffett can afford to buy shares and playfully sip a Cherry Coke when the rest of the world is panicking? 

Buffett’s positions are too large for him to run into the Coke pit and purchase 3 million put options every month or quarter. Yet, with a diversified portfolio of stocks, you own your own mutual fund.

Though a whole text can be (and has been) written on the proper way in which to hedge a portfolio of stocks, the general idea is outlined here to illustrate how easy, fast, safe and necessary this process is to avoid a 50% or greater drawdown in the next market calamity. It is not a matter of if, but when, the next one is coming.

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