You have a stock portfolio. Maybe it’s full of mutual funds or ETFs. Or perhaps you took the stock-picking route and bought your favorite ten companies. At any rate, you are a buy and holder who frets over the coming recession. Or, more accurately, recessions. There will be multiple economic downturns over your investing lifetime, not one.

So what do you do about it? Conventional wisdom says you diversify, build a portfolio with proper asset allocation. You can control the level of risk by shifting monies from stocks to bonds. Want less risk? Up the bond component. Want more potential return? Up the stock component. There’s merit to the idea, no doubt.

But there’s another path to consider: portfolio protection. Let’s call it the Portfolio Protection Path or Triple P. I am specifically talking about buying put options to hedge. As I see it, you have three choices:

One: Always own protection.

Two: Only buy it when you need it.

Three: Always own protection, but come up with a way to pay for it.

Choices, choices

Let’s take a closer look at each.

Protected, Always

If desired, you could always own puts on your portfolio. Forever and ever. It’s a tempting road, no doubt. But it comes with a cost. If you buy one-year, 10% OTM puts as your vehicle (which is the method I like), and if we’re talking about using a broad market index like SPY, then the annual cost will probably be around 3% to 5%.

The beautiful thing about it is your risk moves from 100% of your investment (or, more realistically, 50% – the stock market won’t go to zero), to a mere 13% – 15%. And who doesn’t like the idea of instantly limiting the damage potential of nasty bears to only stealing 15% of a portfolio?

But here’s the problem. That 3% to 5% annual cost for protection adds up. Every single year 3% to 5% of your market gains are eaten up in insurance costs. ‘Tis a burden too heavy to bear. You won’t lose much, sure. But you probably won’t make much either.

Your friends will label you THE WATER TREADER

Protected, Sometimes

Okay, so why not just buy protection when you need it? Own puts when the market is bearish, and then don’t when bullish.

What a splendid idea!

Try it. And then come back to me when you discover no one can consistently nail market tops and bottoms. Sure, there are signs you can watch for. But even those don’t work all the time. By the time the trend turns, and you have evidence of bears roaming the landscape, you’ll probably already be losing around 10%. And implied volatility will be through the roof meaning puts have already become expensive. Those dirty rascals jacked up the price of insurance at the time you need it most!

You can tread this path, but recognize that successfully doing so requires a heap of skill and market timing.

Your friends will label you THE HOT POTATO.

Protected, but Paid for

The third path and the one I’m the fondest of is always owning protection but coming up with a way to pay for it. What if we can push the annual cost of insurance down from 3% – 5% to more like free? That’s exactly what the portfolio protection piece of the Bear Market Survival Guide attempts to do.

The magic (it’s not magic) lies with selling covered calls to help finance the put purchase. To avoid capping our profit potential too quick in the stock, we use far OTM calls.

It’s essentially a collar, diagonalized. A diagonal collar, in other words. And it’s my preferred method for portfolio protection.

Do this, and your friends will call you THE BEAR TAMER.

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