The bull market in stocks that began in March 2009 has been mighty indeed. From its low point, the S&P 500 index has more than doubled, recently hitting record highs. But the market’s pullback in mid-June has left many investors scrambling for ways to shield their portfolios in the event of a complete meltdown. (For more on why stocks may be going lower, see The party could be over for stocks.) To address this angst, financial firms are aggressively marketing “principal-protected” products, designed to shield investors from losses while allowing them to keep some (although usually not all) gains. But those products are notoriously complicated, are generally expensive, and often require investors to tie up their money for years or else face stiff withdrawal penalties.
For a simpler form of crash insurance, consider instead purchasing so-called protective put options for your portfolio. Put options give an investor the right to sell a stock at a preset price up to a specific date in the future — effectively putting a floor on potential losses.
Let’s say that you want a hedge against your large-cap stock holdings. You could buy put options on the SPY, an exchange-traded fund that tracks the S&P 500 index and currently trades at about $158 a share. If you wanted to limit your losses to, say, 10%, you could purchase a put option that lets you sell the SPY anytime during the next six months for $142 a share. You are now protected if it drops below that level. When the option expires, you can purchase more protective puts; most online brokerage platforms offer easy access to options trades.
The cost of the option — effectively, your insurance premium — is $3.50 per option contract, which equates to just over 2% of the amount you insured for the six months. But with a little extra effort, you can pay a lot less. “You can reduce or even eliminate that cost by simultaneously selling a call option,” says Chris McKhann, an analyst at optionMonster.com. Here’s how it works: When you sell a call option, you immediately collect a cash payment in return for agreeing to let someone else buy a stock from you at a predetermined strike price in the future. For instance, you could sell $166 call options on the SPY that expire in six months, and you’d immediately pocket about $3.50 — offsetting the cost of the protective put options.
If the SPY traded above $166 by the call option’s expiration date, you’d be obligated to sell the shares at $166 — a gain of 5.1%. But you would still get to keep the $3.50 you collected upfront. By buying the puts and selling the calls at the same time — a strategy known as a collar — you’ll have limited your potential downside losses to 10% and capped your possible upside gains at 5.1%. And in this example, the basic cost for the portfolio insurance is zero; you’ll only be out the transaction costs. For peace of mind in an uncertain market, that’s a pretty good deal.
A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This story is from the July 22, 2013 issue of Fortune.
