Investors uncomfortable with risk make mistakes, buying and selling at the worst times. Because of the interplay
between the risks you take and your emotions, there are two ways to learn to make rational decisions even when
the markets are hysterical: operate to a pre-determined plan and limit your exposure to losses with which you are
comfortable. The ETF-Discipline is the plan and protective puts are an effective way to reduce risk. Here are four
reasons to consider this strategy.
Portfolio Focus
If you buy and sell stocks or funds to protect your capital, a major sell-off will trigger stop-losses, send ing a large
part of your portfolio into cash. You are not left with the question, of what to do next. What stocks will lead the
recovery and when will it begin? Most of the time, however, the market goes through a scary sell-off and resumes
an uptrend, causing you to scramble to quickly find new investments in order to take early advantage of the new
rally, when the largest gains are often made. Few of us do this well, and we experience losses from account churn.
In a portfolio protected by puts, you hold on to your portfolio and can decide how to reconfigure your portfolio, if
necessary while you asses over days or weeks what the new direction is. You accrue the benefits of long-term
holding: full value from capital gains, no trading slippage, accumulation of dividends, and no taxable events.
Depending upon the severity of the sell-off, the puts either have small losses, or are sold at a profit.
Put protection sets up your portfolio for hedging. In a down market with most positions protected by puts, you can
add a single position that moves inversely to the market, adding further protection portfolio protection.
Less Slippage
Slippage is the bane of traders and setting stop-loss and repurchase prices is an art form. Buying a put is cheaper
transaction than selling a stock or fund, and it retains ownership in an actionable position. Knowing this allows you
to set tighter stops. If you make a mistake, you can sell the put at a small loss or even a profit. Tighter stops mean
you lose less before applying protection and you gain more when the market rallies, because you get back in
sooner.
Faster Market Reactions
On July 12, 2009, my portfolio of 12 ETF’s was entirely protected by puts due to a prior 7% market decline.
Forecasts were ominous and most people expected a down market. Following the strategy, each put had a planned
sell price, and sell orders were in place. On July 15, unexpected good earnings news triggered a sharp 250 point
Dow rally. Like a string of firecrackers, my put sell order alerts fired right off the opening. My portfolio went from
fully protected to fully invested with no action on my part, and it picked up most of the day’s gains. I needed to do
nothing except watch the action.
Puts are more effective than stops if you anticipate trouble. Suppose you own the China ETF, expect a geopolitical
event over the weekend, and are concerned the fund will open with a large downward gap on Monday. A stop-loss
order will not protect you from the gap; it would execute as a market order many points lower seconds after the
open. Instead, buy a put late on Friday. If the ETF gaps down, you have protection and can hold the position until
an uptrend resumes, with the potential to sell the put at a profit.
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