Let's say you own shares in Apple. You believe the company may be vulnerable, but you're not sure you want to sell the shares. So you buy a "put" option on your Apple shares, allowing you to sell them at a set price within a set time period.
If, when the option is about to expire, you want to keep the shares, you do nothing. But if the shares have declined substantially and you don't think they're going to come back, you might be able to sell them at a price far higher than the current market value.
By buying the options, you've insured your Apple shares against risk -- a use of options that many investors aren't aware of. "When I ask investors if they have life insurance, auto insurance, homeowner's insurance, health insurance, disability insurance, I get a lot of 'yeses,' '' says Stan Freifeld of McMillan Analysis Corp., an investment advisory firm that specializes in options.
"When I ask the same investors if they have any portfolio insurance, they look at me as if I had three eyes! Why would someone who apparently believes in the insurance concept not have any insurance on what is probably their first or second largest asset -- their investment portfolio?
The answer is they probably don't know it's available," says Freifeld, whose colleague, Lawrence G. McMillan, explores uses of options in Options as a Strategic Investment.
You can insure your entire portfolio by buying put options on indexes (such as the S&P 500) or by buying "call" options -- giving you the right to buy an underlying security at a set price during a set period – on the VIX, or market volatility index. This way, you can manage risks posed by the current rollercoaster market.
Tactical asset allocation. This is changing your portfolio's percentage of one type of investment versus another based on where the economy is headed. Pring has developed a model for this called Dow Jones Pring U.S. Business Cycle Index.
Pring Turner Capital Group has successfully used this strategy for clients over the years, outpacing the S&P 500 since 2000. The strategy involves buying or selling different types of securities at different points in the economic cycle. For example, the model calls for buying stocks near the trough of a recession and selling them just after the peak of economic expansion. And it calls for buying commodities after the economy begins to grow out of recession and holding them until after growth has peaked and the economy has turned downward again.
Though this tool may be a bit complex for some individual investors to use unassisted by an advisor, it nonetheless shows the kind of proactive approach that the current market requires.
Buying and selling too much can be costly, but in today's market it's often the lesser of two evils. The greater of the two is to believe that you can just buy, hold and sit back without playing defense. When you do this, chances are the market will eat you alive.
Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.