How to Prepare For A Correction Without Missing Out On Upside Potential

Joseph Hogue's picture

Wednesday, July 29, 2015 - 7:30am

by Joseph Hogue

Recent market commentary is starting to remind me of the periods in 2000 and 2008 just before the bottom dropped out of the market. Leading up to the bursting of the tech bubble, for example, analysts increasingly ignored valuation and warnings that earnings expectations were too high. 

Similarly, housing prices peaked well before the stock market's top in 2007, while the Fed had raised rates four times in 2006. Still, no one believed that the economy could slow. 

This time around, earnings for the second quarter are looking weak, the U.S. economy contracted 0.2% in the first quarter of 2015 and estimates for the second quarter are as low as a tepid 2% growth... yet no one seems to care. 

Take Apple (NASDAQ: AAPL), for example. Only one analyst of the 20 covering its earnings release cut expectations for the stock, despite the fact that the company forecast next quarter sales that fell short of expectations. Piper Jaffray (NYSE: PJC) analyst Gene Munster even raised his price target by 6% to $172 per share, more than 37% above the current trade.

Apple is just one example, and while I won't attempt to predict a stock market crash, I will say that valuations across the board are getting heady and several other factors are pointing to headwinds for prices. After more than six years of market gains, it's time to think about protection. The good news is that one option strategy offers protection you'll be thankful for, plus the potential for upside. 

Is The Market Blind To Valuations? 
The price-to-earnings (P/E) ratio of the S&P 500 is averaging 18.5 times trailing earnings. While that's below the heights seen in 2000 and 2009, it's still an 18% premium on the long-term average of 15.7 times earnings. 

P/E Ratio Chart

While the P/E ratio of the market doesn't seem too outsized, it can be misleading. Surging buybacks have lowered share count, boosting earnings per share (EPS). Since 2009, companies in the S&P 500 have bought back over $2 trillion of their own shares, setting a record in February. 

For a truer look at valuation, we can use the price-to-sales (P/S) ratio -- which isn't pretty. Right now, the market is valued at 1.86 times trailing sales. That is 26% higher than the median P/S ratio over the past 22 years and the highest since 2000. 

FactSet forecasts profits for companies in the S&P 500 will contract 3.7% as Q2 results come out, thanks in part to a 4% shrinkage of sales during the period. For reference, that earnings decline would mark the largest year-over-year decline since 2009.

One factor to this end is the stronger dollar, as it continues to weigh on company profits compared to year-ago results. For the cherry on top, the greenback may continue to strengthen as the Fed approaches its first rate increase since 2006, which Fed Chair Janet Yellen recently mentioned could happen this year if the economy continues to improve.

Additional headwinds come from the fact that Europe has yet to see its economy rebound since the global financial crisis, and China's economy is struggling as well. GDP grew just 6.9% during the second quarter, while last year's growth marked the slowest rate since 1990. 

Commodity prices have already plunged on weak global growth; it may not be too long before the rest of the market follows suit. 

Buying Protection With An Upside Kicker 
I don't want to sell out of my positions for fear of general market weakness, though, as there are still some great deals in the market. Instead, when the outlook on the market turns negative, I like to use portfolio insurance to protect my downside and potentially snag some upside potential.

Buying put options on a stock or an index is referred to as portfolio insurance because your right to sell the shares at a specific strike price amounts to a sort of insurance policy against a large drop. The strategy will cost money and moderate your return if prices keep moving higher, but it also offers protection if the bottom falls out of the market.

Buying protection against a slide in the index means you can still keep positions in your favorite stocks while removing some of the general market risk from your portfolio. Buying put options on an index ETF to protect against losses in specific stocks carries an added benefit. An ETF is generally less volatile than a single stock thanks to diversification, so the premium on the put options will be lower. 

The SPDR S&P 500 ETF (NYSE: SPY) holds shares of companies that make up the index to track the price and yield performance of the S&P 500. With SPY trading a few dollars under $210 per share, we can buy SPY Jan 2016 210 Puts for $9.75 per share ($975 per contract). This gives us the right to sell a share of the ETF for $210 on Jan. 15, 2016 with a breakeven price of $200.25 per share ($210 strike price - $9.75 premium). For portfolio protection, I like to buy options out at least six months to defend myself over a couple of quarters. 

I usually devote 3% of my portfolio to buying protection. For example, if you have a $100,000 portfolio, then you would buy $3,000 worth of put options (between three and four contracts based on the current premium).

If the market keeps going up and the ETF closes above $210 on the expiration, our puts expire worthless but we'll still have the gains we made on the rest of our portfolio. If the market falls and SPY closes below $210 on the expiration, we'll be able to sell our put option for a profit, which will help offset any losses on our portfolio.

For example, if SPY were to fall by 10% to $190 by expiration, my option would be worth $20 per share ($210 strike price - $190 market price). That works out to a profit of $1,025 on each contract, for a 105% return from my portfolio protection.

A 10% correction isn't out of the question. Thanks to plunging oil prices, economic weakness in Europe and China and a poor outlook on earnings, SPY fell more than 7% last fall.

Those same factors could lead to similar or greater losses in the near future. And since it may be only a matter of time before the market finally clues in to the reality of lagging sales growth and stock valuations, make sure you have the protection you need.

Note: My colleague Jared Levy recently released a free report on why he believes the likelihood of a market correction -- or worse -- is so high. Like me, Jared currently sees a number of red flags in the market, including many of the same warning signs he saw before major bear markets in China, Russia and even the United States. Using a similar options strategy, he's helped his subscribers net annualized gains of 1,205% and 2,111% this year as stocks fell. You can access his report for free here. 

This article was originally published on ProfitableTrading.com: How to Prepare for a Correction Without Missing Out on Upside Potential​

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.