Five Ways to Protect Your Portfolio From a 20% Market Correction

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As we have looked through research from the firms that we cover on Wall Street, we find that almost everybody expects a pullback. Some see one that is more significant than others. None that we have seen could be as large as the one predicted by Piper Jaffray. The firm thinks that the market could slowly grind higher during the first part of the year to the 2,000 level on the S&P 500. Then what the firm sees may give most investors a pause -- a drop to the support level of 1,600 to 1,650. That would be a 20% decline at 1,600.

A 20% decline would be a full-blown correction. While many on Wall Street agree that it may be healthy for the market after a move of more than 170% from the lows in 2009, any way you look at it, it would hurt. Piper Jaffray also believes that 2014 will be a more volatile year for equities, as the combination of a mid-year election (four-year cycle low) and a new Fed chairman have each historically been associated with higher volatility for equities.

So how do you protect yourself if the predictions are right and we do see a 20% correction? We have five top ways for investors to build some insurance into their portfolios, just in case the Piper Jaffray team is right and we do see a major sell-off.

1. Use the Piper Jaffray interim high 2,000 level on the S&P 500 as a guide, or something close to that, and sell all of your stocks. The problem with that is it could be expensive from a commission standpoint. And if the firm is wrong, you may miss continued upside. If you have your account at a low cost online trading platform, it may be much easier. At a full-service broker, the fees would be sizable.

2. Buy protective puts in your portfolio. It is possible on a dollar-for-dollar basis to hedge part or your entire portfolio with put option contracts. The benefit would be that if you match the put amount to your portfolio assets you could protect against the downside move. However, if the market does not sell off the put contracts could expire worthless. Now most people are happy when their "insurance" does not get used. The problem is unless you buy puts that are way out of the money, the cost will be high.

3. Use a costless collar, and let somebody else pay for your insurance. This strategy makes a ton of sense for people who would like a hedge but are reluctant to pay the large cost to fully insure their portfolio. The strategy here is to sell call options on the stocks you own in your portfolio. You can sell them at the money or out of the money. For instance, if a stock is trading at $50, a $50 call option is at the money and your stock will be called away at that level if it trades there or above on expiration. A $60 strike call option contract is out of the money, and your stock would be called away there. If you own the stock below $50, you will make money if it is called away at $50 and $60. The strategy is to sell call options on the stocks in your portfolio and buy out of the money S&P 500 index puts with the proceeds. While it would be difficult to fully cover a portfolio with this strategy, it would at least give partial protection.

4. Buy a protective exchange traded fund in your portfolio that is short the stock market. One that would work would be the Pro Shares UltraPro Short S&P 500 (SPXU) ETF. This instrument is actually two times short the S&P 500. While it does not move in perfect parity, it is very close. If the S&P 500 goes down 1% this will go up close to 2%. This will help to hedge a portfolio in a more inexpensive fashion. You can lower your cost even more by selling calls against the ETF.

5. Get a stock borrow and actually sell the SPDR S&P 500 (SPY) short in your account. While this is the purest way to short the stock market, there are a couple of issues. First, when you sell a stock short you have to get a borrow from the stock loan department at your broker. Depending on the availability, you pay a percentage amount of the stock as a cost for the borrow. Now fortunately, the SPDR S&P 500 is very liquid and the cost should be low. The other issue is you would be responsible to pay the dividend on the stock you sell short. In the case of the SPY, the dividend is 1.82%. One strategy many people use is to short a stock right after the stock goes ex (or without) dividend. Then you typically have at least three months until the next dividend.

The good thing about the Piper Jaffray scenario is, after the huge sell-off to the 1,600 level, they see the market marching back to close the year out at 2,100 on the S&P 500. Now while that would be an awesome move off a huge correction low, that is the kind of volatility that can give people whiplash. Whether there is a 20% correction, a 5% correction or no correction, it always pays to have some insurance.

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