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Think You Don't Know How to Hedge? Wrong!


Can individuals really learn to hedge for themselves? The answer is always a resounding, YES!

Thirty years ago people thought only stockbrokers could buy and sell mutual funds or stocks. Now its almost commonplace. Actually, I'll estimate that there are nearly 30 million households that have an online brokerage account these days.

How did this happen? I'll spare you the history lesson about how Charles Schwab paved the way in 1979, but suffice it to say the individual evolved and advanced to learn to do it him/herself. Fast-forward to 2011 where millions of trades are executed by individuals on their own computers buying and selling stocks; mixing it up with the big boys everyday.

One of the most popular questions we get when talking about our book, Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term, is, "Can individuals really learn to hedge for themselves?" The answer is always a resounding, YES! But don't take our word for it, just look back at history and see how the little guy has taken to the street.

Individuals understand limits versus market orders. They understand what the bid and ask are. They understand technical analysis terms like "moving average" or "support and resistance." They learned and they want to learn more. They especially want to learn more about what gives them any advantage they can get toward success.

So why is it so hard to believe that the individual can learn to buy protection through the options markets? I understand that the options market is intimidating. There are lots of terms like "strike price," "premium," "expiration," and "contracts." But I contend that the options markets are only as complicated as you want them to be. The same is true with the stock market.

Don't believe me? Compare the day-trader to the long-term investor. The long-term investor makes a few decisions as to why they like a company and go buy it. It may be for fundamental reasons, diversification, rebalancing, or even because of a turning trend. Today those aren't complicated concepts, but 20 years ago this was only the language of the Wall Street pros.

Day traders take this to the next level. They use downloadable platforms with tools like NASDAQ Level 2, technical analysis, pattern recognition and automated trading systems. Clearly the masses have come a long way. My point is, the investor chooses how complicated they want to let stocks get for them. This is the same for the options market.

People use options all the time in everyday life, they just might not know it. Lets take for example a put. A put gives the holder the right to sell stock at a specific price by a specific time. This should not have lost you, but if it did, I'll say it another way. The put guarantees the stock owner to get a certain value for their asset no matter how bad it gets smashed in the market. Ever hear of anything like that before? How about insurance? Yes, I just said you can insure a stock position.

We all use insurance, but lets look at its components. There is the value of the asset you are protecting like a house, a car or your life. There is the deductible, which is the amount you're willing to cover yourself in case disaster before the insurance kicks in. There is the premium you pay for the insurance. And there is the amount of time you want to be insured. So far, all familiar terms.

When it comes to a protective put, these are the exact components you need to know, they just have different names.

Sure there are terms that the insurance agent uses behind the scenes that you have no idea about like payout probabilities or the weighting of health risk factors. Those kind of factors exist in the options market as well, but you just don't need to know about them unless you plan on opening up your own insurance company.

Lets compare the terms we know about:

In many ways, the protective put is easier to manage than insurance. Take for example the premium. In the options market there's no shopping around to pick the provider that can save you 15% or more. The open market gives a fair valued price.

Or in the case of the asset being protected, insurance doesn't give the flexibility or power of choice to the holder like the options market does. Take your car, for example. As it gets older and depreciates in value, you're at the mercy of your agent to determine how much you pay.

Sure, some people will say that the option sharks are just waiting for the next sucker to jump to chew them up and spit them out. But this is no different than the trading environment millions of individuals decide to wade into everyday when they decide to buy a stock like Netflix (NFLX). Some will say that the individual isn't experienced enough to trade options against the street. Hmmm; this all sounds familiar and its complete garbage.

(See also: Buy and Hedge: Authors Jay Pestrichelli and Wayne Ferbert on Smarter Investing)

If you're interested in hearing more from Jay & Wayne on hedging and ETFs in the future, let us know, and we'll keep you posted on how. But for now, buy their book.

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No positions in stocks mentioned.
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