In traditional asset allocation, the way to reduce risk is diversifying your dough out of stocks and into bonds. Since bonds carry less volatility than stocks (not to mention a negative correlation), they dampen overall portfolio fluctuations – particularly in times of crisis. But every pro has its con. In exchange for reduced risk, a higher allocation to bonds comes with lower expected returns.

Therein lies the rub. If you want a portfolio with more firepower – buy more stocks. If you want one that’s less likely to blow you up – buy more bonds.

Forests have been lost in the endless debate on how to strike the right balance between the two. But with the advent of derivatives, creative investors learned they had a new toy to play with – put options. Some say you can sidestep bonds altogether, and use puts instead to limit risk.

Indeed, this is one of the advantages we cite in our Bear Market Survival Guide.

Here’s an example using a $100k portfolio. Remember, the garden-variety-once-a-decade-or-so bear market sees stocks fall 30%. But some of the more vicious types cut equities down by 50%. So, as a back of the envelope expectation, long-term investors should expect to see their stock portfolio drop 30% to 50% once in a blue moon.

That means if you threw the entire $100k in something like SPY, you better be comfortable with witnessing a drawdown of $30K to $50k. Otherwise, you’re bound to panic and sell your stocks in the hole thereby locking in massive losses and doing irreparable damage.

If that seems like too much risk, then back off your stock exposure a bit. For instance, if you are only willing to see your $100k drop $10k to $15k, then perhaps a $30k allocation to stocks is more appropriate with the other $70k going into bonds.

But here’s where puts can help. What if instead of dropping your stock allocation all the way down to 30% of the total portfolio, you could still invest close to 100% in stocks, but still cut the risk down to a mere $10k to $15k?

Sounds intriguing, no?

The trick lies in buying puts.

Birds of a Like Feather

Investor A: Invests $30k in SPY and $70k in AGG (a Bond ETF).

Expected Loss in a -40% bear market: $12k (this is assuming AGG stays flat. In reality, your bond holdings would probably rip higher)

Investor B: Invests $96k in SPY and $4k in SPY puts

Expected Loss in a -40% bear market: $13k

Note the similarities? We can accomplish similar risk reduction with buying puts versus throwing the bulk of the portfolio into bonds. But with the put route, we get to keep virtually the entire nest egg in stocks.

Would you rather place some 70% of your capital on bonds to accomplish the risk profile you desire OR would you rather place a mere 4% in put options to achieve the desired exposure?

Now, there’s no doubt that puts carry some baggage of their own. Namely, time decay and the complexity of deciding which puts to purchase (you have a million choices) and how to manage them.

I found the video posted by Christian Sisson in last week’s Tackle Today missive very interesting. Watch it if you haven’t and you’ll learn more of the details regarding using puts over bonds as your risk reducer.

In the Bear Tamer system outlined within the Bear Market Survival Guide and monthly Mastermind meetings, we kept things simple by purchasing a single one-year, 10% OTM protective put for every 100 shares owned.

But not everyone uses that method. Some elect to buy multiple far (like really far) OTM puts for every 100 shares owned. If the delta is low enough (1 to 3) the cost is negligible, but because of the large quantity purchased, the gains can be massive if the market crashes.

This is a topic I’d like to explore more in future Mastermind Meetings for all you Bear Market Survivalists out there.

To Summarize

Step #1: Learn the protective put strategy.

Step #2: Experiment with using various months/strikes/quantities to achieve the optimal balance between insurance cost and benefit.

Step #3: Consider adding covered calls to the mix to reduce the annual drag of the put purchases.