Simple way to crash-proof your portfolio
Wednesday marks the fifth anniversary of the Flash Crash, when the S&P 500 (INDEX: .SPX), Russell 2000 (Exchange: .RUT) and Dow Jones industrial average (Dow Jones Global Indexes: .DJI) collapsed in a matter of minutes, momentarily wiping out trillions of dollars in market cap in just a few seconds.
And as memories of the crash remain fresh in many investors' minds, some market participants are looking for the best way to protect their portfolio. With options prices low, one trader says there is a relatively inexpensive way to insure your portfolio.
"I think the best idea when it comes to hedging is to try to keep is simple," options trader Mike Khouw said Tuesday on CNBC's " Fast Money ." Khouw noted that with the CBOE Volatility Index (the VIX (INDEX: .VIX)) near all-time lows, prices for put options remain relatively cheap. A put option gives a trader the right to sell a stock for a set time and for a set price.
Read More 'Flash crash' 5 years later: What have we learned?
"The VIX and the S&P 500 are negatively correlated," he noted. "When the market sells off, volatility tends to rise." And according to Khouw, low VIX prices present an attractive opportunity to buy insurance in the event of a sudden crash. "Purchasing volatility when it is low would mute the effects of a downturn on the rest of one's portfolio." In other words, buy protection when you can, not when you need to.
So to make a hedged protection play in the event of an unexpected crash, Khouw suggested buying what's called a put spread on the SPY (NYSE Arca: SPY), the ETF that tracks the S&P 500. Specifically, he looked at the August 210/189 put spread for a total of $4.75. In this strategy, the trader is protected if the SPY is between $205.25 and $189 by August expiration. "This trade gives protection in a 10 percent range," said Khouw, a CNBC contributor.
Of course, "hedging comes at a cost," Khouw noted, and there could be a simple reason why puts are cheap. It's been four years since the S&P 500 (INDEX: .SPX) has had an official correction of 10 percent, meaning that even if the dollar cost of buying puts is now low, if recent history is any indication, that insurance may expire worthless, making it in the grand scheme of things more expensive than it appears.
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