How to Buy “Retirement Crash Insurance”

w w w. A f t e r s h o c k I n v e s t o r R e p o r t . c o m
How to Buy
“Retirement Crash Insurance”
By Andrew Packer and the Aftershock Investment Team
A Newsmax Media Publication
The Aftershock
A Publication of Newsmax & Moneynews
Investor Report
Special Report
How to Buy
“Retirement Crash Insurance”
I
By Andrew Packer and the Aftershock Investment Team
nvesting is one of the most powerful concepts
mankind has ever devised. Simply put, by
accumulating capital and then investing it, you
put it to work. Done right, your money starts
making money. The important thing on your
end is to keep an eye on your positions and
decide the best investments. Then all you need
to do is sit back and let time do the rest.
If you invest in bonds, you know you’re going
to get regular, steady payments. If you invest in
small companies with huge prospects, you may be
in for a wild ride. If you invest in large, established
companies, you’ll get some growth and some
regular — but growing — payments along the way.
While investing can be simple, it can also be
dangerous. While the power of compound interest
is well known, and every financial adviser under
the sun likes to trot out charts showing everincreasing growth, the fact of the matter is, markets
do sell off. They have bad years. Bond prices can fall
— and some bonds may even stop their payouts.
Diversification solves the problem of any one
investment going sour. But sometimes the entire
market will crash all at once as investors urgently
sell in a bid to raise cash. A few bad weeks in the
market can undo years of scrimping, saving, and
investing.
But there are ways of protecting yourself from
these rare but recurring market crashes. It involves
“crash insurance.” You don’t need to put up too
much capital to use it responsibly, and best of all
you don’t need to use it often. But by doing so, you
can mitigate your losses and even come out ahead
as needed.
In this report, you’ll see what “crash insurance”
entails, how it can be used to protect your portfolio, and a few suggested ways to use crash insurance
to turn every 1 percent decline in the stock market
into gains of as much as 3 percent.
Why Insure Your Investments?
We insure the most important things in our
lives. Our expensive cars are protected against accidents. Our property is protected against the ravages
of mother nature. We protect our families with disability and life insurance against the unthinkable.
Yet, when it comes to one of the most important areas of your life — retirement — it’s rare to
find someone willing to suggest that you insure it
against the unknown.
Remember, you buy insurance because of
unforeseeable and dangerous events. You don’t buy
automobile insurance because you expect to get
into an accident. You don’t buy property insurance
hoping an earthquake will knock your house down.
In investing, markets don’t move in a straight
line. Yet most people just invest with an optimistic
“glass half full” perspective.
It’s important to at least consider that something bad can happen. While worst-case scenarios
are extremely unlikely, that doesn’t mean the possibility of them occurring is zero. We buy insurance
to protect our home, our cars, and we even insure
our expensive toys…but not our life savings and
investments.
That’s a downright shame for investors, especially for those near or in retirement. One bad year
in the market, like 2008, can wipe out decades of
careful saving and investing. But it doesn’t have to
be that way.
There are two main ways you can cheaply add
some insurance to your investments as well. They
allow you to profit when the stock market takes a
hit.
You don’t need to insure your entire portfolio,
of course. Given the stock market’s tendency to rise
over time you’d be better off only partially insuring. And that’s the beauty of “crash insurance.”
These insurance “policies” are only “buy when you
need it.”
Insurance You Can Buy Only
When You Need It
Unlike your mandated annual policies for your
home or car, you don’t need to have crash insurance all the time. To do so would guarantee that
you’d lose small amounts of money. But crash insurance is about making money from stock market
crashes, to offset your losses from elsewhere.
And the great thing about crash insurance is
that you can wait for the start of a crash. You can’t
buy automobile insurance if you’re seconds away
from getting into an accident. You can’t buy fire
insurance after your house goes up in smoke. A
pre-existing medical condition may lock you into a
health insurance plan — or kick you out of a plan
— that doesn’t adequately cover you.
So with crash insurance, you can wait until the
start of a major correction and still see your newlycreated insurance policy pay off.
Of course, like many insurance premiums in
life, it’s far cheaper to buy if the insurer thinks
you’ll never use it. You’ll pay more if a crash catches you unaware. But even if you pay more up front,
you’ll still get some benefit out it.
Again — and this bears repeating — most of
the time, these market crash insurance policies will
lose money. But that’s what you WANT. It’s a good
thing. Markets tend to go up over time. That’s why
investors can buy and hold the stocks of quality
companies for decades, or hold speculative positions for shorter amounts of time. You’re putting
the odds on your side when you follow the overall
market trend. Over the long term, that’s up.
Of course, there are countertrends, and when
the market falls, it tends to do so much more
sharply and quickly than when the market rises.
But there’s no need to sell everything you own
and move to cash when the market corrects. With
transaction costs, inflation, and lost opportunities,
that just guarantees that you’ll lose money. By buying portfolio insurance, you’re placing a bet against
your portfolio with a small percentage of your net
worth.
Insuring against inevitable market corrections
helps to keep you from losing your shirt. Ultimately, adding a little “crash insurance” to your portfolio
strikes the right balance between greed and fear. It
ensures that you’re still invested in the market after
it finishes crashing.
That’s a good thing, as most of the market’s
top-performing days have come at the end of bear
moves. So you aren’t punished for being a little
fearful.
It also ensures that you spend a little money on
positions that go against markets when they get
too greedy. When the greedy pigs of the market get
slaughtered, you’ll come out comparatively better
even if you only have a little bit of portfolio insurance.
So what methods work well for providing portfolio insurance? There are two ways for individual
investors to easily write their own policies.
Portfolio Insurance Policy #1: A Liquid
Way to Run Opposite the Market
The first, and easiest method to create a portfolio insurance policy is with exchange traded funds,
or ETFs. ETFs trade daily like stocks and can hold
Andrew Packer has been an avid investor since childhood. Starting with bullion and collectible coins, he expanded into
stocks as a teenager. He has since added options, real estate, and bonds to his personal portfolio. His investment approach
is based on value, growth at a reasonable price, special situations, and any other opportunities presented by the market.
After earning a BA in economics, Andrew honed his analytical skills while working at various companies, including real
estate research and private equity firms. Andrew has written investment services on small-cap value investing, shorting, and
contributed big-cap value investments to a monthly publication.
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able in the ETF world.
If the S&P 500 isn’t
your preferred tracking
30%
index, you can buy the
20%
ProShares Short Dow30
10%
(DOG), which seeks to get
0%
the exact inverse perfor-10%
mance of the Dow Jones
-20%
Industrial Index. Or, for
-30%
shorting the small-cap
-40%
heavy Russell 2000 Index,
-50%
you can buy the ProShares
Short Russell2000 ETF
20082009A J O 2010A J O2011 A J O2012A J O2013 A J
(RWM).
Over the past five years, the Dow Jones Industrial Average (red line) has risen
Now let’s say you want
30 percent, while its inverse ETF, DOG (blue line), has fallen by over 55 percent.
to short a different asThis illustrates the key component of buying market crash insurance — it’s a
set class — bonds. With
short-term investment, not a long-term buy and hold strategy.
interest rates near zero for
SOURCE: Yahoo Finance
the past five years and the
Federal Reserve buying
bonds to pump $85 billion into the economy each
a diversified basket of different companies. They’re
month, it seems that bonds have little reason to dewidely liquid, and tend to have substantially lower
cline in price right now. But the Fed has suggested
fees than their predecessors, mutual funds.
tapering (reducing) its bond-buying at some point
ETFs can come in broad flavors, like funds that
in the near future.
track the overall market. Most investors are already
The mere announcement of the Fed stepfamiliar with funds like the SPDR S&P 500 ETF
ping back on its bond buying has led to a modest
(SPY), which allows investors to buy “shares” of the
bounce in bond yields … which means falling
S&P 500.
bond prices. If you think there’s more room for a
ETFs also can come in smaller niche categories
decline, there are several bond ETFs that can prolike tech stocks, dividend growers, gold miners,
vide you positive returns on falling bond prices.
bond funds, or just about anything under the sun.
The first is the ProShares Short 7-10 Year TreaBut an even smaller niche of ETFs is designed
sury (TBX). This fund, as the name suggests, looks
to zig when the market zags, and rise when the
at shorter-duration bonds which tend to be less
market falls. These are known as inverse ETFs.
volatile when interest rates change.
For example, one such ETF that we recommend
For more aggressive bond bears, the ProShares
as a simple way to buy portfolio insurance is the
Short 20+ Year Treasury (TBF) seeks to gain from
ProShares Short S&P 500 ETF (SH). Rather than
the inverse of longer-dated bonds, which tend to
invest by shorting the 500 companies that make
react a little more severely to changes given their
up the S&P 500 Index, it uses options and other
longer duration.
derivatives to try and obtain an exact negative corAll of the above inverse ETFs are simple to unrelation to the market.
derstand. They aim to gain exactly as much as the
So if the S&P 500 falls 10 percent, this fund
market loses. But speculative investors might want
should rise about 10 percent.
to look at leveraged inverse ETFs.
Likewise, if the stock market were to rally, this
Leveraged ETFs seek to double the returns
fund would fall. That just goes back to the point
from a falling asset. Rather than make a 1 percent
that you shouldn’t buy crash insurance until the
gain from a falling market, these funds are looking
market is starting to crack. This fund has an annual
to gain 2 percent.
expense ratio of 0.89 percent as well, quite reasonInverse ETFs Rise When Markets Fall, but Not Always at the Same Rate
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There are some leveraged ETFs that seek to gain
triple, leading to a 3 percent gain for every 1 percent decline. But these products are so scarce and
leveraged that the average investor should outright
avoid them.
Buyers should be aware, however, that the leveraged ETF strategy uses more leverage and, like its
unleveraged counterparts, doesn’t always correctly
track the underlying market. These funds often
bleed money to the point where a major market
correction could still lead to losses depending
when you buy them.
That’s not just because these ETFs are leveraged. It’s also because the daily reconciliation
of these inverse ETFs can magnify the problem.
The daily reconciliation is important for all these
inverse ETFs because they track DAILY movement,
not long-term movement. Daily often follows long-term movements, but
not always. So, the market may be down 20 percent over two months, but the inverse ETF might
only be up 16 percent as a result.
Investors looking for a simple form of broad
portfolio insurance should consider the aforementioned inverse ETFs and stay away from double
or triple inverse ETFs due to their performance
problems.
Simply investing a small amount of money into
these inverse funds should go a long way to minimizing losses in your overall portfolio when markets correct. But it won’t offer the best protection.
If you’re looking to buy portfolio insurance for
pennies on the dollar, or simply looking for a more
leveraged strategy to protect your portfolio, there’s
a better, but more complex way than inverse ETFs.
Portfolio Insurance Policy #2: A Leveraged
Bet Against Markets and Individual Stocks
for Pennies on the Dollar
Our second strategy for retirement-saving market crash insurance doesn’t involve funds.
It instead involves derivatives, which are essentially “side bets” on the market.
Say that you’re out at a bar drinking with a
friend of yours and you find yourselves talking
about Apple (AAPL). He’s bullish on the stock, and
you aren’t. You make a “side bet” that the price will
fall.
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You put up $50 now with the bet that in six
months the share price will be $350. Your friend,
seeing the current share price of $425 and blinded
by bullishness, agrees that if the price is indeed
$350 or lower in six months, he’ll pay you $200.
That kind of “side bet” occurs daily in markets
for most major stocks and various ETFs that track
the broad market. Only in the investment world,
these are known as options. A bullish bet based on
the possibility of rising stocks is known as a call
option, a bearish bet is a put option.
The option you “bought” with your $50 from
your friend is a put option. If shares of Apple aren’t
at $350 in six months when the option expires,
you’re out $50. If shares are at or below $350, however, your $50 becomes the $200 you agreed on!
The reality is, many people pass over options.
They’ve wrongly heard that options are just for
professionals who “know what they’re doing,” that
options are too risky, and too complicated for regular folks.
Let’s point out two things: First of all, crossing the street is dangerous if you don’t know what
you’re doing. As with any investment decision, you
just have to be knowledgeable first.
Secondly, for the purposes of crash insurance,
you can buy one or two put options to make a
bearish bet on the stock market while still holding
an existing portfolio. Of course, one or two options
won’t cover your entire portfolio against losses.
But that’s the point of crash insurance. A home
insurance policy won’t prevent a fire, nor will car
insurance keep you accident-free. Rather, these
forms of insurance help you out after these events
occur.
To try and ensure your entire portfolio with
options could get into an area of speculation that
over-leverages you and puts your wealth at risk. By
using options to keep market insurance a small
part of your portfolio, you’re protected against big
losses without putting too much of your wealth at
risk.
Simply defined, an option is a contract that
gives you the right (but not the obligation) to buy
a specific security, such as stock or an ETF, at a specific price, at a certain time.
Sound complicated? It’s not. Options are used
all the time in the real estate world.
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Let’s say you are in the market for an investment property. You see a home that you want to
purchase as a rental, but perhaps you’re not quite
ready to pony up all the cash to actually buy it.
Yet you don’t want some other buyer to swoop in
and get the property either. So you sign an option
contract with the owner, and give him a good faith
deposit of $1,000.
That contract gives you the right, but not the
obligation, to buy the house at a certain price
($100,000) at a certain time (three months from
now). It’s similar to a stock option in that respect,
although some real estate options might be vastly
different depending on conditions.
Now three things can happen in the next 90
days.
1. You can buy the house for $100,000
2. You can sell the contract to somebody else.
3. You can choose not to buy the house and walk
away from your $1,000 deposit.
So let’s look at these three scenarios more
closely. Let’s say, upon doing some research, you
find out that the house is a historical structure and
the value of the house is actually $200,000.
With scenario #1: You could buy the house for
$100,000. Afterwards, you could try to flip it and
bag the extra $100,000, or you could rent it out
for the income. In this case, it cost you $101,000
— your option to buy the house plus the purchase
price, so you make $99,000 profit, or about a 98
percent return.
With scenario #2: You sell the contract on the
house. This would be a quick way to make a profit.
In places like South Florida, this was an extremely
popular way to make money during the real-estate
boom.
In our case, with a $200,000 valuation on the
house and a contract to buy at $100,000, the value
of the option should become about $100,000. The
option buyer could then exercise the option at
$100,000, pay an additional $100,000 for the home
from the buyer, and own a home valued — and
bought — at $200,000.
Since you only paid $1,000 for the option, you
still make the $99,000 profit — but it’s on the
$1,000, not the $101,000 you would have had to
pay if you bought the house outright. That gives
you nearly a hundredfold return on your money!
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A Third Form of Crash Insurance
If the stock market looks like it’s going to trade
sideways for a while, or decline slightly for a bit over the
next few months, you can sell call options against your
existing stock positions.
This is known as “selling covered calls” because if the
options are exercised, your shares will be “called away”
from you and you’ll have capital gains (or losses) to deal
with. Because you’re selling the calls, you immediately
receive cash. The catch, however, is that if the stock rises
above the strike price of the options you sell, the option
will be expired.
That is a safe, conservative way to generate income in
a flat or down market. And it’s a great way to get some
extra income out of your stock portfolio. But in the
case of a bigger market decline, you’ll get much higher
percentage returns from buying put options as a form of
crash insurance instead.
In both of these scenarios, your $1,000 deposit
became worth roughly $100,000. Talk about a huge
return on your money.
But . . . let’s say the opposite happens. Suppose
you find out the house is sitting on a landfill that
was previously a pet cemetery? Nobody wants to
pay that much for a home built there. The property,
in your eyes, is really only worth about $50,000.
With Scenario #3: You still have the option to
buy the house for $100,000, but who in their right
mind would do that? Doing so would guarantee an
instant $50,000 loss.
So in this case, the best thing you can do is
walk away from the contract. You suffer a much
tinier loss: your $1,000 deposit money.
Yes, that’s painful, but . . . isn’t that a heck of
a lot better than losing $50,000? Using options in
this case limited your losses to $1,000 loss versus
$50,000 potential loss from buying the house outright.
So to recap, an option is a contract that gives
you the right (but not the obligation) to buy a specific security, such as stock or an ETF, at a specific
price, at a certain time.
In this example, you had a contract to buy a
house (but you are not obligated to do so) at a
specific time and at a specific price. The contract
to buy was a call option. The contract with your
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friend that Apple’s stock price would be
lower was a put option.
Why Put Options Are Better Than
Short-Selling for Crash Insurance
Profit: Long Put Option With $40 Strike Price
$4,000
$3,500
$3,000
ABC Put Option
$2,500
By buying a put option, you’re bet$2,000
ting on stocks to go down, so it’s a lot
$1,500
like shorting a stock. But there’s a big dif$1,000
ference. With a put option, you’re taking
$500
on a lot less risk. Let me explain…
$0
Shorting a stock is a pretty simple
($500) 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70
concept if you think through how it
works. Rather than seeing rising prices,
By buying a put, your profit is made when the underlying stock
say you expect prices to fall. There are a
price stays below the strike price of the option. In this example,
few reasons for that.
the put option will cost the borrower the entire premium if the
You may expect a company’s hot new
stock price is at $40 or above. At lower stock prices, the value
product to be a dud. You may have noted
of the put option increases and profit is higher.
that the company’s financials don’t seem
SOURCE: OptionsXpress
to match its earnings per share — and
there may be some financial shenanigans
shareholder you borrowed from.
involved. Whatever your reasons, if you expect the
•Most people who lend out a stock to be sold
share price to be lower than it currently is, then
short also charge a fee to do so.
you’d want to “short” the stock rather than buy
•If the stock goes down to zero, you’ll only be
shares.
able to make a 100 percent return. Yet even a
Here’s an example:
bankrupt company will trade for a few pennies.
You borrow 100 shares of, say, Bank of America
•If the stock keeps going up, your risk is
(BAC) at $12. You then sell those shares to obtain
essentially unlimited!
$1,200 ($12 x 100). That money stays in your “margin” account. Then Bank of America falls to $6 over
•What’s worse, sometimes the government will
the next few months.
outright restrict short selling (like they did in
At that point, you decide to close out the posilate 2008).
tion. To do that, you must return the shares you
Fortunately, put options provide a far better
borrowed. To do that, you would “buy to cover,’”
way to bet against stocks, ETFs, or the broad marpaying $600 ($6 x 100). Then you keep the difket without having to put up huge amounts of
ference — in this case $600. You doubled your
capital.
money!
Options don’t require a margin account (so you
But doing so came at a high cost:
can actually make these trades in retirement accounts and thrive in times of market downturns),
•Shorting stocks requires a margin account with
but you do have to be qualified by filling out an
at least 50 percent cash, in case the trade goes
extra form, given the risk involved.
against you. (Say you sold Bank of America at
Best of all, the most you stand to lose is what
$12 and it went to $20, you’d need to either sell
you pay for the option (called the premium). If you
out your position at a loss or put more cash up
pay $2 per option (really $200 since all options are
to cover the potential shortfall.)
for 100 shares), the most you can possibly lose is
•Also, not every stock is available to easily
$200.
borrow, particularly small-cap stocks.
During the market panic in 2008, the SEC
•If you short a dividend-paying stock, you’re
took the extraordinary step of banning short sales
the one who gets to make that payment to the
against hundreds of stocks. Initially focused on
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financials, it spread beyond. But options buyers had
the opportunity to enter into positions to bet on
the price movements of these stocks.
If markets fell as hard and fast as they did in
late 2008, a few thousand dollars in put options in
the right areas could easily return tenfold. If used
to bet against a company that’s about to go bankrupt like some big banks did, those options could
have returned a hundredfold or even more.
That’s extreme, of course, but if you buy a put
option right before a stock declines 10 percent in
a day on poor earnings, you could see returns of
fivefold or more.
Just remember: Options have risks, and using
them both inside and outside of portfolio insurance can significantly magnify your investment
gains or your losses. These changes can occur
quickly, and in a far greater percentage swing than
the underlying stock. You need to tread carefully.
That’s why timing is much more important on options than in an inverse ETF. You can hold the inverse
ETF indefinitely, but options come with an expiration
date.
If the underlying stock or ETF doesn’t move far or
fast enough, this strategy can lead to the entire loss of
the options premium you paid.
It’s a small price to pay for the extreme leverage,
and another reason why you only need to buy crash
insurance when you need to.
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Conclusion: Never Fear a Market
Correction Again
With portfolio insurance, you need never fear
another market crash undoing years of wealthbuilding in matter of days. You can protect your
gains in a variety of ways. For most investors, the
simplicity of inverse ETFs can provide a shelter
from falling markets.
For more sophisticated investors, buying put
options on market-wide ETFs or even specific
stocks can offer the kind of crash protection that
can pay $5 for every $1 invested.
Market crash insurance is a must in falling markets. However, most of the time, you won’t need to
have much in the way of insurance, as markets tend
to rise over time. It’s there when you need it, and
unlike many other forms of insurance in life, you
can decide the level of market insurance you need
at a given time.
Disaster can — and will — strike the markets,
much as earthquakes will hit California, tornadoes
will blow through Nebraska, and hurricanes will
brush over Florida.
Just as you protect your home, your cars, and
your toys, so you should also protect something
just as valuable if not more so: your chance to
retire and enjoy a comfortable and profitable retirement.
The Aftershock
Investor Report
Financial Publisher
aaron dehoog
Editorial Director/Financial Newsletters
Jeff Yastine
Senior Financial Editor
ROBERT wiedemer
Editor
michael berg
Art/Production Director
phil aron
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