The Intelligent but Worried Bull

Afraid to Act?

Worried Bull
Worried Bull. Google Images

Markets Rise; Markets Fall

As much as most of us like to believe that we are talented when it comes to predicting when the stock market will move higher or lower, the truth is that markets have their ups and downs. Sometimes the bulls win and sometimes the bears win. And that should be okay for the intelligent investor.

A sad truth is that too many individual investors unload their holdings after a significant decline.

This not only results in locking in a loss but even worse -- those who sell at prices that turn out to be near the lows miss out again by failing to participate in the next large rally. This is (clearly) no way to increase your net worth over the long term.

Good general advice is easy to find: If you are an individual investor, do not try to time the market when investing for the long term. While it is understandable that people become frightened during market downturns and euphoric during rallies, the surest road to success is to follow your investment plan without trying to guess where the market is headed next. If you do not feel sufficiently qualified to make your own plan, there are many reputable investment advisors (who charge a fee, not commissions) who offer excellent guidance.

Options to the Rescue

If you are someone who felt so uncomfortable with stock ownership during declining markets that you just had to sell when the pressure of ever-increasing losses became too difficult to bear, then the problem may be that you have been too aggressive in your stock picking.

One way to alleviate that problem is to become a passive investor, using index funds.

Another way to avoid so much discomfort during bear markets is to hedge your portfolio with one of the more conservative option strategies. Options -- the conservative and versatile investment tool -- can help you avoid making decisions that result in a financial catastrophe.

If you are a long-term investor (short-term traders have a different mindset and a different trading style) who occasionally thinks in terms of owning safer investments that come with built-in insurance against a huge loss, then options can be your salvation. But please understand: Options must be used wisely to achieve the peace of mind that comes with safety.

Option Strategies for the Bullish (but Frightened) Long-Term Investor

  • Very aggressive technique that allows you to remain fully invested, but which protects the entire portfolio. NOTE: "Protects the entire portfolio" does not mean that you will never lose money. Instead, it means: If you pay a premium -- just as with an insurance policy -- then all losses become limited to a predetermined (and hopefully acceptable to you) sum. In other words, a stock market tumble will result in a monetary loss, but your portfolio will survive.
    You can achieve these results by choosing either of the following plans:
  1. Buy put options. Either buy one out option for each 100 shares of stock in your portfolio. Or buy enough put options on the S&P 500 Index (SPX) to cover the majority of your loss when the market tumbles. This only works when your portfolio is highly correlated with the index whose puts you buy.
  1. Replace each 100 shares of stock with one longer-term, high Delta - in-the-money, call option. You can never lose more than the cost of the option, limiting losses. The cost of this protection is the time premium (i.e., the part of the option premium that exceeds the option's intrinsic value) paid for your options
  • Limited protection method that cost zero out of pocket  cash (instead you to collect a cash payment), but which limit your potential profits. That is no small sacrifice for the investor who is truly bullish but is very attractive to the investor who is looking for the market to rise.
    The best way to adopt this plan is to sell (write) one call option for each 100 shares of stock owned. This strategy is known as covered call writing.
    An equivalent strategy that can be applied when investing new cash into your market portfolio is the naked sale of put options. The risk/reward is the same as writing covered calls when the strike price and expiration are identical. 

    The bottom line for the intelligent investor is that there are simple option strategies that you can use to accomplish two things: First, you remain invested in the market, participating when markets rally. Second, you own protection for all, or part, of your investment portfolio -- just in case a bear market emerges.