Kyle Anderson: When the markets are down like they have been in 2014, it’s smart to know how to protect your money from a stock market crash.
The Dow Jones Industrial Average has dipped 2.8% in 2014 and the S&P 500 is down 0.7%. Some experts see the current market sell-off continuing through the month of February.
While other investors worry about the markets tumbling further, you can start protecting yourself from a potential stock market crash.
Here are three strategies to prepare today.
Protecting from a Stock Market Crash: Inverse Index Funds
Inverse exchange-traded funds are designed to perform in the exact opposite of the index they are tracking. Trading inverse index funds can be one of your best hedges against a sharp market decline.
For instance, the ProShares Short S&P 500 (NYSE: SH) will post the inverse results of the S&P 500. In January, the S&P 500 posted a loss of 3.6%. Accordingly, SH was up 3.5% in that month.
Investors who were bearish on the S&P 500 could have purchased shares in the ProShares Short S&P 500 in January and offset some of the losses they experienced elsewhere with that 3.5% gain.
Other inverse funds include ProShares Short Dow 30 (NYSEARCA:DOG) and the ProShares Short QQQ (NYSEARCA:PSQ), which track the inverse of the Dow and the Nasdaq-100, respectively.
Protecting from a Stock Market Crash: Put Options
Buying protective put options is another strategy for investors anticipating a market crash.
When investors buy put options, they are signing contracts giving them control over 100 shares of a stock. An investor will buy a put option when he or she expects the value of a stock to decrease.
Every option has an expiration date, which is the third Saturday of the expiration month chosen. Once the expiration date passes, the option is terminated.
With a put option, the investor buys the right (but not obligation) to sell 100 shares of a stock before the expiration date. The more the share price depreciates compared to the initial purchase price, the more valuable the put option becomes.
Here’s how it works:
Say an investor wants to insure a stock he holds against a market drop. He can buy a put option that gives him the right to sell shares of the stock at a certain value, or “strike price.”
Once the value of the stock dips below the strike price, the investor is “in the money” – meaning the position is profitable, and the option contract itself is worth something. The investor can do a couple of things.