Why You Shouldn’t Be Afraid Of Options And Futures

Buy-and-hold is the standard investment advice for rookies. They tell young people to grit their teeth through bear markets like those of 2001 and 2008 where some investors lost half their savings. They say you will eventually make back your losses over time if you stay in the market. They call that “diversification across time.” They suggest old folks like me should have most of our money in good bonds because we don’t have the time left to make up for losses, but we can’t do that because the Fed has forced interest rates to near zero for almost a decade.

One reason that diversification across time is a bad idea for young people is simple math. If a market crash takes half your life savings, the market will have to double in order to make up your losses. That may take five years, but then you’re only back where you started and have missed five years of potential gains. The math looks bad.

Few investors would buy a $300,000 house and not buy insurance on it against fire, flood, tornados or hurricanes. A few more might go without insurance on a $100,000 BMW, but not many. Consider that the odds of a bear market in stocks that steals say 25% of your savings are far greater than your house burning down or totaling your BMW. Bear markets happen every decade. So why not insure your investment in the stock market as you would your house or car?

Cover Your Assets

The market isn’t likely to go much higher the rest of this year because as the last post showed it has already out distanced profits by quite a bit. So unless profits improve dramatically, the best an investor can hope for is a flat market with the potential for a major drop. But what if the market does reach higher levels and sets new records as it has several times this year?

Covered calls are great tools for situations like this. A covered call is a strategy for an investor in which he sells or writes call options in the stocks he owns. By selling a call option, the investor is selling to another investor the right to purchase the stock the seller owns at the strike price. The strike price should be higher than the price of the stock at the time of the sale of the option, or what is known as an out-of-the-money (OTM) strike price.

The strategy produces a win/win situation for the seller of the option when the market has risen to nose bleed heights. If the market remains flat, the seller of the option keeps the premium. If the market falls, the premium replaces the lost value of the stocks and gives the investor time to sell.