Why Now's the Time to Protect Your Portfolio

With investing, it pays to buck the prevailing trend. The contrarian approach often works, whether it's picking up shares of unloved stocks or selling high-flying investments right before a crash brings them back to earth.

Strangely enough, though, that phenomenon allows nervous investors to protect themselves from market declines at exactly the time they should be most worried: after a huge advance. Conversely, if you wait until a decline actually starts to happen, then buying portfolio protection isn't nearly as good a deal.

Later in this article, we'll look at how a strategy involving put options can help you hedge against possible declines in the market after its nice bull run over the past several years. First, though, let's look at why many people get portfolio protection exactly wrong.

To understand why this counterintuitive phenomenon occurs, you have to understand market psychology. When stocks are going up, average investors feel increasingly good about the future prospects for the market. Even though shares are getting more expensive, the recent experience that these investors have of their stocks making money produces a positive feedback loop that leads them to want to buy more shares. The last thing on their mind is selling -- even if it locks in a paper profit that isn't yet real -- because they don't want to miss out on further gains in the future.

At the other extreme, average investors typically seek out the security of principal guarantees and other risk-averse investments after sizable declines have already happened. Even though stocks are arguably safer after such declines -- at the very least, they don't have as much to fall from already lower levels -- investors nevertheless want to stop the bleeding, and they're willing to pay up for the privilege.

That supply and demand mismatch explains why the price you pay to buy protection through put options fluctuates. When stocks are moving higher, the S&P 500 Volatility Index (INDEX: ^VIX) tends to be low. But when stocks crash, watch out -- volatility usually spikes, and with it, the cost of put options rises as well.

For instance, look at volatility levels recently. Just last week, the VIX hit its lowest level since mid-2007 -- before the market meltdown, before the financial crisis, before all sorts of crazy days for the stock market. With yesterday's decline, the iPath S&P 500 VIX Short-Term ETF (NYS: VXX) jumped nearly 10% -- but even so, it's down more than 70% from its highs during last fall's market swoon.

The simple way to take advantage of low volatility is to buy put options. Because the price of put options is based in part on volatility, they're cheap under current conditions -- especially because the prices of underlying stocks are quite high. That gives you a unique opportunity to hedge against further losses.

In addition, using put options instead of just selling stock outright has a number of advantages. When you sell shares in a taxable account, you have to worry about generating capital gain, which can raise your tax bill substantially. Put options, on the other hand, protect you without forcing you to sell your shares and incur capital gains taxes.

More importantly, selling shares means that you give up any additional gains. Put options, on the other hand, put you in control -- if your stock continues to rise, your options will expire worthless, but you'll still get profits from the stock's move upward.

Of course, just because the overall market isn't volatile doesn't mean that every stock out there is offering cheap puts. For instance, (NAS: VVUS) got great news from an FDA advisory panel about its Qnexa obesity drug, but until the stock gets final approval from the regulatory agency, put options will remain expensive.

In addition, financial stocks still face special challenges. Bank of America (NYS: BAC) has puts that are far less expensive than they were back in August. But despite a nice run upward for the stock, volatility levels are still higher than they were this time last year -- before investors understood the full downside potential for the stock.

Finally, story stocks often have volatility spike, making options more expensive. Apollo Group (NAS: APOL) disappointed investors recently with falling enrollment figures despite posting better earnings than analysts had expected. Concerns about the for-profit educator's future growth increase downside risk for the stock.

If you're afraid of a correction, don't wait for the first sign of a pullback. Now's the time to take maximum advantage of low volatility to buy cheap protection with put options. After a correction actually starts, it'll be too late to get the best deals possible.

Of course, if you're a long-term investor, it's far less important to protect yourself against short-term drops. To discover some stock ideas that could be a good fit for you for the long run, check out The Motley Fool's latest special report on retirement. Inside, you'll find three promising stock picks for long-term investors. It won't cost you a thing, but don't wait; get your free report today while it's still available.

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At the time thisarticle was published Fool contributor Dan Caplinger thinks volatility is overly feared. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always in the right place at the right time.

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