Editor’s note: As the 2022 sell-off continues with no end in sight, we revisit one of Genia’s timeless lessons: How to use put options to build portfolio insurance…and profit in a falling market.
You’ve probably heard the market maxim, “Don’t fight the Fed.”
You may also have heard the phrase, “Clichés are cliches for a reason: because they’re true.”
There is simply no getting around the fact that equities are directly impacted by Fed policies.
The evidence is everywhere.
In 2020, the Fed’s “easy money” policy drove stocks higher after the COVID crash.
And today, the Fed’s aggressive interest rate hikes are sinking the market.
So far this year, the Fed has raised rates from zero to 3%, with the promise of further hikes in the coming months. As a result, we saw the S&P 500 lose 23%…and mortgage rates more than double.
But it’s not necessarily a bad thing that you can’t fight the Fed… Knowledge is power: Once you understand how the market reacts to Fed policies (and vice versa), you can prepare for the following.
Since we know to expect more rate hikes before the end of the year (and since we know the market will likely react negatively), we can plan accordingly.
My favorite way to play on falling stock prices is to build “portfolio insurance” with put options.
Similar to life insurance, portfolio insurance protects an investor against an adverse event. Specifically, put options, when used correctly, allow you to profit from a decline in a stock, a sector, or the entire market.
Here’s how they work…
When you buy a put option, you have the right (but not the obligation) to sell the underlying security (stock or ETF) at a specific price (strike) before a certain date (expiration).
If the price of the underlying security declines, the value of the put option increases – and the faster and steeper the decline in the asset, the more you can potentially earn on your put trade.
To buy a put option, you will have to pay a sum of money upfront. Think of it as an insurance premium…
But, like an insurance premium, it’s the most you’ll lose if the asset doesn’t eventually decline. And if you’re right, you’ll get way more than you paid for the put option.
In other words, when you hold a put option on a specific security, you are positioned to profit from the decline in that security.
You might think it’s too late to start buying insurance amid the market sell-off.…
But nothing could be further from the truth.
For one, no one really knows where the market is going. As Frank explained in his emergency briefing, it makes sense to maintain hedges at all times – for safety when the market is rallying…and for profit when it isn’t.
Second, a market drop often feeds on itself: when investors start to flee, others get spooked and do the same, causing more pain for your “long” portfolio (assets you think have an advantage )…but more profit for your short, put-based positions. (The tech-heavy Nasdaq is already down around 33% this year – and positions in some of these stocks have already generated gains of up to 270% in a month for my Money flow trader advisory.)
Finally, put options offer investors a way to go against the grain…and profit when the market is down, which it is today. As you can see from the chart below, there is almost no place to hide in this selloff – all asset classes are suffering.
Of course, options are a tool to be used with care… If you get the direction of the asset wrong, its volatility, or the timing of your trade, your put could expire worthless. So only invest what you can afford to lose on the “insurance premium”.
But if you plan carefully and understand the risks…a series of well-placed sell trades will not only provide valuable protection against a falling market…but also incredible profits.