How To Hedge Your Portfolio Against a Second Wave of Coronavirus

Don’t dump your stocks yet. There’s a better way to safeguard your portfolio.

virus

There’s nothing like a warm, sunny day to trigger the desire to get outdoors and share a laugh with your friends. Of course, these days that means a keeping at least six feet apart as you enjoy a beverage and watch the clouds roll by.

Recently, over “social distanced” drinks with a couple of my friends, one successful businessman in my group said to me, “The economy is a mess, why shouldn’t I take all my money out of the stock market just in case there is a second wave of coronavirus?”

I get my friend’s concern. Thirty-eight million Americans are unemployed, the global supply chain is a mess, business and vacation travel aren’t coming back anytime soon, many restaurants will never come back, and neither I nor my dog can get a haircut!

And on top of that, two of the most successful investors of all time spoke quite negatively about the stock market. Here was what these legends said:

Stanley Druckenmiller: Risk/reward in stocks is the worst he’s seen.

David Tepper: This is the second-most overvalued stock market he’s ever seen, behind only 1999.

And with all those negatives lined up somehow the Nasdaq is hovering around all-time highs! How is this even possible?!?!

What’s with the mixed messages in the stock market?

My working theory about the resilience of the market is based on two factors:

  1. The Federal Reserve has essentially said, “we got this,” and will continue to flush the system with so much liquidity that the economy will be able to survive this economic tsunami.
  2. Traders and investors believe that the best of the best in science and technology will figure out testing and a vaccine sooner than expected.

That being said, I 100% would understand if my friend wanted to sell his stock holdings, raise cash and wait out a second wave of coronavirus that could decimate our economy.

Don’t let your portfolio suffer the economic setbacks of coronavirus
However, as I told my friend, you don’t necessarily need to sell your stocks, as there is an options strategy that can hedge his portfolio against another deep market sell-off … and that strategy is buying put options.

During a spout of market volatility, I recommended to subscribers of my Cabot Options Trader and Cabot Options Trader Pro advisories that we buy our first market puts in months, as my trading signals were beginning to flash warning signs. This recommendation was well timed, as the S&P 500 promptly fell 3% after my recommendation (sometimes it’s better to be lucky than good).

If you are unfamiliar with puts, here is a definition and graph of a generic put buy:

A put purchase is used when a decline in the price of the underlying asset is expected.

This strategy is the purchase of a put at a specific strike price with unlimited potential for profits. The maximum loss on this trade is the amount of premium paid.

For example, the purchase of the XYZ 100 put for $1 would only risk the $1 paid. If the stock were to close at $100 or above at expiration, the put would expire worthless.

If the stock were to go below $99, the holder of this put would make $100 per contract purchased per point below $99.

As for how this coronavirus situation will play out over the long term, and the impact it will have on the market, it’s truly anyone’s guess. However, with put options my friend and all investors can continue to maintain their portfolios with the knowledge that they are hedged just in case the market gets hit by a wave of declines.

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