Protective Puts Tip

When you feel anxiety about the general market conditions, don't wait until several weeks after the indices have declined to determine you should protect your portfolios. Instead, identify support levels of the major index that correlates closest to your portfolio. If the index is trading very close to its support level, this is a good time to purchase portfolio insurance, in the form of long put contracts (large portfolio sizes may look into futures contracts instead).

A good starting point for investors is to reduce their portfolio exposure by approximately 30 percent if using long put contracts. Remember, long put contracts reduce market exposure, it does not eliminate it. For investors who want to eliminate risk - exiting the market altogether may be the right decision.

Here's a quick example on reducing risk. If the portfolio has 1,000 shares of stock across several securities, and the portfolio is closely correlated with the S&P 500, the investor may want to reduce the risk by purchasing the equivalent of 300 shares of the SPY (S&P 500 tracking ETF).  Purchasing out-of-the-money put contracts totalling 300 deltas is the share equivalent and can be purchased to help reduce that risk.

Typically the investor should buy the puts if he or she feels strongly about a fairly significant market retracement. Small market pullbacks may not justify long puts since the puts have negative theta.