Don't Panic -- Before You Sell, Consider Buying Puts

What a horrible day for the market. September is indeed a cruel month. With the Dow down 7%, I'm sure lots of people were and will be clicking the sell button on all their positions. They don't care what price they're getting, they just want out. I can't say I blame them. After all, our leaders, with fear and confusion in their eyes, are telling us that the financial system can collapse.

Experts, like Marc Faber and Adam Hewison are telling us to buy gold. Faber says buy physical gold, and store it outside the United States. Others are advocating buying the Yen. I think these are good proposals. Physical gold is better if cash becomes worthless, although it's hard to buy food with it if it's stored in another country.

Faber has also mentioned, and I agree, that if you own a company's stock and your currency becomes worthless, at least you still own a portion of the company. There are plenty of great businesses (e.g., companies that sell products we use daily and that should stay in business) being sold off indiscriminately. If you're holding these, ask yourself why you bought in the first place and where they'll be trading in the longer term.

Have people around the world suddenly stopped smoking? No, but Philip Morris International (PM) is down over 8%. Have people stopped drinking and imbibing in other addictive substances? No, and it seems reasonable to assume that they'll drink and smoke more (look at history--it seems that no matter how bad times got, people still had enough money to drink and smoke). But look at BUD and UST, both of which are slated to be bought by the end of the year. Will people stop buying toilet paper, soap, and similar products we use daily? No. Yet Procter & Gamble (PG) and Johnson & Johnson (JNJ) are down around over 3%.

No one knows where the market will go. It can keeping falling, certainly. Look at the NASDAQ after the tech bubble burst. But it may also go up, given the profound bearish sentiment. Let's say the bailout passes and actually works. If you sell now, just as those who sold after 9/11/01, you'll miss the rally. But there are great perils in holding, your gut maybe saying. That's absolutely true. Shares of the best, most recession proof companies can and do plunge along with the market.

Before you hit that sell button, however, think about how much more you're willing to lose by holding on to your shares. Can you stomach another 10 or 20% while you wait for a recovery? If you can't, sell your shares. You'll miss out on any rebounds, but you won't lose any more. If you can stomach some further pain in exchange for staying in the market and positioning yourself for a potential recovery, consider buying puts on your positions.

By buying puts, you are setting a limit on how much more you can lose, while leaving open potential gains. Granted that this strategy would have been better implemented last week or earlier, it is still worthwhile to consider. With puts, your loss is limited to the following through the option's expiration: price at which you bought the stock + put premium - put strike - any dividends paid out.

For example, suppose you bought PG at $70 a share. Procter closed at $66.75 today. If you sell at that price, you'll lose $3.25 per share, with the potential upside being whatever rate of interest cash pays. Let's say you keep the stock and buy puts. A January 2010 put at the 70 strike closed at $7.70. Let's say you buy it at that price. While your potential gains are unlimited, the most you can lose through January 15, 2010 is $70 + $7.7 - $70 (the strike price), or $7.7 a share less any dividends. (No doubt another strike or expiry date may work better, but this is just an example.)

As another example, suppose you bought Kraft (KFT) at $35 a share. The January 2010 35 strike put closed at $5.40. If you buy one put for every hundred shares, the most you can lose between now and January 15, 2010 is $5.40 a share less any dividends you receive. Your potential gains are unlimited.

If you don't mind limiting your potential gains, you can offset your loss by selling covered calls. Sticking to the Kraft example, the January 2010 45 strike call's last bid was $0.45. Suppose, as above, you bought KFT at $35, bought the Jan '10 35 puts for $5.40, and sold Jan '10 45 strike calls at $0.45. The most you can lose is now $4.95 a share, less any dividends received. The most you can gain is $5.05 a share plus any dividends you receive.

Think about your holding period and your risk comfort level. Before you sell your stocks, look where their puts are trading. It may be worthwhile to buy them and stay in the market. If you have a plan, that you thought up before the crisis, stick with it. If you have no plan, formulate one while the market is closed. Then stick with it.

Don't panic.

Disclosure: At the time of writing, I own JNJ, PG, and PM.

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