Over the last few sessions, the S&P 500 (^GSPC) dropped more that 3%, causing some panic among investors who are wondering whether this is the beginning of a bear market.
Conversing with fellow investors over the last few days, I often discouraged an extremist approach to investments, i.e. holding uncompromising views of a security’s rise or fall. Instead, I promote a more evolved approach that takes into account all the circumstances (including risks), and then decides whether the security truly represents an investment-worthy candidate. In doing so, an investor prepares himself for different outcomes, which helps him manage his risk more effectively.
Not only is it important to ...view middle of the document...
For instance, let’s say you own 500 shares of Novavax (NVAX), a clinical-stage biopharmaceutical company, currently trading at $3.85. While the long-term outlook looks favorable, you are concerned about short-term stock price volatility, esp. considering the number of clinical tests’ results to be released over the next few months. Based on your fear, you should purchase five puts at a suitable strike price, which would protect your position from an undesirably high loss. If the stock falls, you minimize your losses.
Moreover, purchasing put option gives you the right but not the obligation to sell your shares. So assuming the puts about to expire are favorable to hold, you may decide to rollover to the later expiring puts.
Industry related fears
This fear usually occurs when you have sizable exposure to a particular industry. If you have industry specific fears, whereby you believe a particular industry may experience some near term correction or slow down, you have a couple of options.
One way you can hedge against an industry’s decline is through purchasing comparable quantity of puts on a sector ETF. For instance, let’s say you have considerable exposure to healthcare industry, but are concerned that the industry might face a slow down in near term, then you can buy puts of an appropriate healthcare ETF, such as the iShares US Healthcare (IYH) ETF.
Likewise, the other common industry-specific ETFs used for this strategy include US Utilities (IDU), US Consumer Services (IYC), US Energy (IYE), US Financials (IYF), US Industrials (IYJ), US Telecommunications (IYZ), US Basic Materials (IYM), US Technology (IYW) and US Telecommunications (IYZ).
Alternatively, you can also buy industry specific inverse ETFs for the same purpose. In the above-mentioned example, one could consider purchasing ProShares UltraShort Health Care (RXD) ETF that seeks to correspond to two times the inverse (-2x) of the daily performance of the DJ US...