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The Only Portfolio Protection You'll Ever Need

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One of the best ways to lose money in the markets is to be a perma-bear.

We all know that there will be another bear market in stocks one day -- nothing goes up forever -- but we have no way of knowing when that decline will begin. So while the bears will eventually be proven right, those who heed their growls too early will, at best, miss out on gains and, at worst, lose a significant amount of money.

As investment guru Peter Lynch noted, "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."

Lynch was the manager of Fidelity Magellan Fund from 1977 to 1990 and delivered an average annual return of 29.2%, nearly double that of the S&P 500 during that time. This time frame included Black Monday, the largest one-day crash in market history in October 1987 and three separate declines of 20%.

Below is a chart that illustrates how listening to perma-bears could be hazardous to your wealth. It shows some highly publicized market calls following the 2009 market bottom.

Nouriel Roubini is an economist who earned the nickname "Dr. Doom" for his forecasts of the subprime mortgage crisis. Analysts and investors scoffed -- that is until his predictions came true in 2007. The problem is that Roubini remained bearish until early 2012, missing the first three years of the market's rebound.

Another well-known bear is David Rosenberg, formerly of Merrill Lynch and now with Gluskin Sheff. He also warned of the U.S. housing crash and credit crisis prior to 2007, but he remained a bear for nearly two years after the market bottomed.

Source: Nomura Research

This chart is a powerful reminder of the cost of clinging to a bearish outlook in the face of a rising market. Imagine if you had listened to these two prominent bears and remained in cash from 2009 to 2012.

Instead of moving to cash, some bears buy portfolio insurance in the form of put options.

When you buy a put option, you have the right to sell shares of a stock or ETF at a predetermined price for a predetermined amount of time. If the price of the underlying security falls, the price of your put option goes up. However, if the price of the stock or ETF rises, the put option could expire worthless (although you will never lose more than you paid for the option).

Let's walk through a current market example to see how a put option would work.

SPDR S&P 500 (NYSE: SPY ) is trading near $205. A 20% decline would push shares down to about $164. To protect yourself against a potential drop, you could buy a put option with a strike price of $205 that expires in March 2016 for about $15.50.

If SPY falls to $164, that put option would be worth at least $41 ($205 strike price minus $164 share price).

Assume your account value was $100,000 and you would lose 20% of that amount in the market decline. One put option would cost $1,550 since each option controls 100 shares, so buying this put would have reduced your stock holdings to $98,450. A 20% loss would reduce that amount to $78,760. The put would be worth $4,200, so your total account value would be $82,960.

Without the put option, your account value would be $80,000, so the put decreased your loss, but only from 20% to 17% in this example.

If stocks are unchanged a year from now, your account would be worth $98,450 instead of $100,000, and your insurance would have cost you 1.6%.

But let's assume you purchased one put option for $1,550 and stocks gained 10% instead. Your stocks would be worth $108,295 and the put would be worth nothing. In this case, the put cost you $1,705, or 1.7% of lost appreciation in your stocks. This loss includes the opportunity cost associated with buying the put.

As you can see, the potential benefits of buying put options can be fairly small in dollar terms. Yet the cost is relatively high, especially when you consider that the foregone profits reduce your compounded returns over time. Because stock prices move up much more often than they move down, the cost of buying put options could have a significant impact on your long-term wealth.

How I Prepare For A Correction

Rather than moving to cash or buying puts options, I prefer a third option as a way to prepare for a correction -- selling put options

When you sell a put, you generate immediate income in return for the promise to buy the stock later if it falls to a price that you believe is attractive.

For example, I believe SanDisk (NASDAQ: SNDK ) is a company with great long-term potential. It is a leading manufacturer of data storage solutions, including thumb drives, memory cards for cameras and chips used in laptops and servers.

Analysts estimate SNDK will deliver earnings per share ( EPS ) of $5.26 this year, and they expect earnings to grow at an average rate of 16.8% a year over the next five years.

The PEG ratio compares a stock's price-to-earnings (P/E) ratio to its EPS growth rate. When the P/E ratio is equal to the EPS growth rate, analysts consider the stock to be fairly valued. By this metric, the fair value of SNDK is about $88 a share.

With shares currently trading at $83, SNDK looks undervalued. But I would prefer to pay less than the current market price, especially if the market pulls back. I'd rather buy SNDK about 15% below its fair value, or around $75. I can sell a put at that price to generate income, essentially getting paid to wait for a pullback.

Put options with a $75 strike price that expire in April are selling for about $1.22 per share. Since each contract represents 100 shares, I generate immediate income of $122 per contract.

This put will obligate me to buy SNDK at $75 a share if the stock trades for less than that on April 17 (the last day these options can be traded). Buying 100 shares of SNDK at $75 each would cost $7,500.

My broker will require a margin deposit of 20%, or $1,500.

If SNDK is trading above $75 when this put expires, I keep the $122, earning an 8.1% return in 37 days over my $1,500 deposit. I'd also have the chance to sell another put. If I could make a similar trade every 37 days, that would work out to a return of 80% a year while I wait for a pullback in SNDK or a broader market correction.

If SNDK is trading below $75 when this option expires, I will purchase shares at $75, which is the price I wanted to buy the stock at. When I take into account the premium from selling the put, I actually lowered my cost basis to $73.78, so I am getting an even steeper discount to fair value.

This is why I think selling puts is the best way to prepare for a market downturn. Rather than moving to cash and missing potential gains or buying puts that offer surprisingly little downside protection and can lower returns, I am committing myself to buying stocks at a discount. Corrections can be scary, and this strategy forces me into action when stocks go on sale.

Additionally, selling puts allows me to profit as the market continues to rise. We have been in a powerful bull market for the past two years, and during that time, every single trade I've closed has been a winner. I've gone 85 for 85 with annualized gains averaging 53%.

For those of you interested in this strategy, I put together an eight-minute tutorial explaining step by step how you can start using puts to generate income today. Before you start making preparations for the next market correction, I urge you to watch this.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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