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A Hedge for the Little Guy By Stephen J. Butler

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In an attempt to shed light on a Biblical passage, Woody Allen once said,
"The lamb will lay down with the lion, but the lamb won't get much sleep."
Today, most of us are perplexed, shell-shocked investors who can relate
closely to Woody's lambs. News reports suggest that the Federal Reserve
Board is clueless about the direction of the U.S. economy.

The ever-inventive securities industry offers a helping hand in the form of a put on the S&P 500 Index. You can purchase this "insurance policy" for an amount equal to approximately 3% of your annual returns. If the market stays exactly even for the next two years, you will have lost 3% per year. If the market rises by 10%, you will have a net 7% gain. But, if the market loses 20%, you will have had a net loss of only 3%, the one-year cost of the "policy."

If you are worried about the market declining further, the great advantage of
a put is that you do not have to unravel investments that have performed well over many years. Within a retirement plan, such as a 401(k), trading out of a stock or mutual fund you have owned for several of the "good years" and moving to cash does not trigger any taxable event. However, in a taxable environment, selling a mutual fund or stock can be extremely expensive. With 100% certainty, you will lose somewhere between 25% to 35% of your gains to taxes.

This huge potential tax hit partially explains why many people who would have moved to more conservative positions during the market bubble of the late 1990s postponed doing anything - to their regret.

That raises another question: Why do people hesitate to change their investment mix or to sell big winners within a retirement plan, where there is no tax hurdle? Psychological factors are at work here. "Status quo bias" is a powerful emotion that actually serves people well during normal times. However, these are not normal times, and someone approaching retirement may want to keep his or her stocks and mutual funds while casting an anchor until this uncertainty blows over.

Stock market history provides a perspective. After the crash of 1929 and 1930, the market rose significantly in 1931, only to retreat in a long downward spiral over the following seven years. More recently, we had a market that went essentially nowhere for seventeen years (from 1965 until 1982).

For any number of reasons, then, some of us may be willing to pay what amounts to an insurance premium to protect our retirement money. That brings us back to the concept of a put.

A put is a right to sell something in the future at a higher price than you can buy it for at that future time. Therefore, if something goes down in value, you have the right to buy it at the low price and sell it for the higher price that someone contracted with you to pay. (The opposite of a put is known as a call. A call is the right to buy something in the future at a lower price than its current market value).

The concept of a put is not new. Phoenician traders invented it over 2,000 years ago. What is new is that you can buy a put on the value of the S&P 500 index. The purchase of puts is called "hedging." Sophisticated trading firms, known as hedge funds, employ this strategy to protect their wealthy clients from market declines. By buying a put on the S&P 500, you are harnessing the same technique for your portfolio that these hedge funds apply to billions of dollars.

Why is the S&P 500 index such a critical benchmark? For openers, it is the world's most popular single investment. Almost all major mutual fund and brokerage houses offer versions of this investment, which mirrors the performance of the 500 largest public companies in the U.S. The value of these companies makes up 70% of the entire U.S. stock market. The other 6,000 public companies are only 30% of the market.

Studies show that 70% of any single stock's long term performance, on the average, is a function of what the market as a whole is doing. It's the "rising tide phenomenon." This explains why most mutual funds, over time, generate results that are reasonably close to the S&P 500 index. Even famous past winners, like Fidelity Magellan, only beat the index by a little over 1% per year on average, and that was back when they were considered "hot."

Protecting against the downside, no matter what your fund selection happens to be, can be largely accomplished by buying a put on the S&P 500 Index. Of course, if your sole investment happens to be the S&P 500, you have a better shot at creating exactly the arithmetic outlined above. You can't, for example, hedge against a technology fund that loses 50% of its value by using a broader-based S&P 500 index put. However, if it walks like a duck, quacks like a duck and looks like a duck; it IS an Index fund. Most broad based mutual funds perform close enough to index funds to be protectable by an S&P 500 index put.

Once you have a grasp of the pricing and the mechanism, you can experiment with different time frames and pricing. For example, if you stand to lose 10%, then the put designed to create that limitation would be cheaper to purchase because you are paying someone to absorb less risk than to guarantee today's value of your account. Options also have different expiration dates with different prices as a result.

Here's another scenario. Say you can't bear to part with your tech funds but want to be protected when they plunge. You can buy puts on a security that bundles together the 100 largest stocks on the Nasdaq, which trades under the symbol QQQ. Or you can buy a put on the Nasdaq index itself.

One place to gain a better understanding of these instruments is by calling 1-888-OPTIONS, an information line operated by the Chicago Board of Options Exchange (CBOE). Any brokerage firm or the brokerage services department of the major mutual fund companies can also sell you options and provide you with information.

On a cautionary note, stay away from any other kind of options. Most amateurs lose money in massive amounts when they try to trade options independently of a well thought-out strategy such as the hedging technique here. A golfing buddy, who has made millions as a professional options trader, says the industry has a term for the times when options trading is popular with the public. The professionals say, "The fish are back."

BUYandHOLD does not recommend any securities. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy.