At last check, the DOW is down another 1.5% for the day, but at one point had briefly fallen below the critical 11,000 level for the first time in 2 years. The VIX index is over 10% to 28.25. There are ways to protect your portfolio in these types of markets, such as put options, shorting stock, or covered calls. Notice I didn’t say sell into the panic (to the vultures of wall street!). I’ll briefly cover those 3 options here.

Put options are best to buy in times of low volatility as the market goes up, so with the VIX volatility index as high as it is, the premiums on put options is just to rich for me. As an example, consider an August Put option on the Dow Jones industrial average. The DIA ETF can be used to model the performance of the dow jones industrial average and sells for 1/100th of the price of the dow jones. With the DOW Jones trading at 11,100, the DIA trades at 110. The DIA is optionable, so put options are feasible, but the premiums are currently very high. Take a look at the DIA August 110 Put, which currently goes for $350 per contract, which is nearly all extrinsic value. That means for your DIA Put portfolio protection insurance to pay off, the Dow Jones would have to take another beating down to the 10,750 level by August 15 just for you to break even!

Shorting stocks or indexes is another option and mathematically simpler then put options since there is no extrinsic value and time decay to worry about. You can short the DIA at its current level if you think its going lower, or you can utilize the proshares Ultrashort Dow (symbol DXD) to gain double exposure on the short side of the Dow Jones. But even the biggest bears in the room (myself included) know that rallies can and do happen, and often at just the right moment to crush the life out of the shorts.

That leaves us with the covered call, which benefits greatly when the VIX peaks during high volatility markets. Take the same DIA as an example. If you bought 100 shares of DIA for $11,000, you could then sell an August 110 call contract to the market for approximately $380. It’s called a covered call because you have covered yourself first with the ownership of the underlying, in this case 100 shares of DIA. When you sell the August 110 call, you are obligated to sell your 100 shares of DIA for $11,000 anytime prior to August 15th, but only if the call buyer exercises his or her right to buy. With this covered call scenario, let’s consider a few possible outcomes:

  1. DIA closes the August 15 trading session at 104. Your 100 shares will have lost $600 in value, but the August 110 contract you sold will have expired worthless, giving you a gain of $380, giving you a total net loss of only $220. The covered call sale protected $380 of your loss.
  2. DIA closes the August 15 trading session at 110. Your 100 shares will be even in value, but the August 110 contract you sold expires worthless, giving you a gain of $380. That’s a 3.4% gain on your money in just over a month, when the securities you bought remained flat.
  3. DIA closes the August 15 trading session at 115. Your shares are exercised, and you are paid $11,000 for them (110 strike that you sold * 100). But remember, you have also previously collected $380 for selling the 110 contract so you are still a winner in this case and make the same 3.4% gain on your money in just over a month.

Of course even with the covered ed call protection in place, there are still risks, especially with runaway markets. In the same example as above, consider the possibility that the DIA ends the August 15 trading session at 125. Despite that huge run up, you are still obligated to sell your shares for only 110. Regardless of how high the DIA gets to on August 15, you still are obligated to sell your shares at 110, so your upside is capped in this case to just the $380 you sold the covered call for.

Disclaimer: As always, there are no guarantees of accuracy for this or any information on Geldpress. And no information on Geldpress is meant as a recommendation. Make your own financial decisions, or consult your own financial adviser.

For additional reading, please purchase:
Covered Calls and LEAPS--A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading)
Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper