This latest news caused the major stock market indices to fall lower for a few trading sessions while investors tried to figure out the best way forward.
Whenever uncertainty hangs over the market, I’ve noticed a tendency for new and experienced traders alike to turn toward put option buying as a way to hedge their portfolios.
On the surface, this strategy makes sense as put options increase in value whenever an underlying asset goes down. So, you’d assume that they’d make a great trading vehicle whenever the stock market heads lower.
However, in my experience, buying puts at a time when everyone else in the market wants them is actually one of the worst things you can do. And that’s because you’re going to pay an outrageous price on those put options as a result of rising demand.
Think of it this way.
Let’s say that you live in a coastal region of the country and your house is at risk of flooding in the event of a bad storm. Chances are, you probably have flood insurance that you pay for every month in case disaster strikes.
But let’s say you’re one of those people who likes to live life on the edge, and you don’t buy flood insurance when you purchase your house.
Well, if a storm comes and you’re trying to buy insurance a couple of days before a storm is supposed to hit, you’re going to pay an outrageous price for something that you could have gotten a lot cheaper if you’d planned ahead.
And that’s because you’re trying to buy a hedge against property damage at the time when it’s most needed.
The same is true when you go to buy put options during a market correction. You’re going to end up paying more money for all of that implied volatility when everyone else is trying to implement the same protective strategy as you.
Now, I get that you want to protect your portfolio, especially when everyone around you is starting to panic. But personally, I wouldn’t just buy put options right after we experience a market bounce.
Instead, I’d buy a bear call spread that stands to profit from the underlying asset trading lower in the near term while also sheltering me from downside risk.
Alternatively, I’d scale down my position sizes to ensure that I live to trade another day. This helps me stay nimble should the market take a sudden turn in either direction.
Take it from someone who’s blown up their portfolio in the past: It’s not worth tanking all of the fantastic gains you’ve made trying to follow the crowd.
Instead, focus on proper risk management and position sizing during down periods. Your portfolio — and your pocket — will thank you for it.
Disclaimer & Disclosures The information in this email is intended for informational purposes only and does not guarantee specific results as there is a high degree of risk involved with trading. Also, our traders are real traders and may have financial interests in the companies discussed. Please see our Terms and Conditions for more information.
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