TOP FARMER INTELLIGENCE – Weekly Perspective by Bryan Doherty
PROTECTING FALLING STOCK PRICES
We’ll start this Perspective with a disclaimer: We are not predicting the stock market to decline. In fact, we’re not predicting any change in the stock market. Yet, after 11 years of trending higher, the Dow Jones stock index could be ripe for a top. In March 2009, the Dow bottomed at 6,469 and recently traded over 29,000. In just under 11 years, it has more than quadrupled in value, gaining 22,560 points from its low, an increase of 349%. The argument can be made the market has accelerated substantially since the election of 2016, when the market bottomed at 17,418 and has tacked on nearly 12,000 points in this short window of time. Markets often accelerate as they move toward a top or bottom.
If you have money in the stock market, what can you do to protect yourself? There are various methods of reducing risk. One is to move out of stocks and head to the sidelines for safer cash alternatives like money markets or CDs. There are likely many who did this in 2012 through 2015 when the market already saw substantial gains. These investors have missed out on much of the bull market. Maybe the market high isn’t anywhere in sight. Who knows? Yet, perhaps a better method than moving to cash is to protect the downside risk of a falling market through the use a put options, a debt instrument on the Mini Dow futures.
The Mini Dow is traded at the Chicago Board of Trade and mirrors the Dow Jones Industrial Average. One tick represents $5.00 in value. Therefore, if the stock market moves 1,000 points (ticks), this represents a $5,000 move in the futures market. Purchasing a put option against the Mini Dow futures can be done to establish a price floor. When you purchase a put, you are buying an instrument that gives you the right (not the obligation) to be a seller of the underlying futures. In this example, the underlying futures is the Chicago Board of Trade’s Mini Dow Futures. Think of a put much like you might think about insurance, in that it protects, yet may never be used during its life. Options have a designated life. What you pay for an option is called premium. Premium (plus commissions or fees) is the maximum risk when purchasing a put, again like insurance, where you buy a level of coverage for a fixed value.
As an example, if you purchased a 28,000 put in the June Mini Dow and paid 740 points, this would cost you $3,700 (prior to commission or fees). If the stock market were to drop to 20,000 by expiration date on June 19, this option would be worth 8,000 points less 740, or 7,260 points. The dollar value would be 7,260 points multiplied by $5.00 per point, or $36,300. You would be able to utilize this money as an offset of declines in your stock prices. You were able to maintain ownership of your stocks. This could also be a benefit if dividends were paid or you didn’t want to exit for tax reasons (capital gains).
Trading is not for everyone, and a thorough knowledge of how options and futures work is necessary before entering a position. We wanted to make you aware of a financial instrument that could be applicable to those who have investments in stocks or perhaps retirement plans invested in the stock market. Be sure and communicate with your advisor to determine the best course of action for you.
If you have questions on cash marketing strategies or would like ideas for your operation, contact Top Farmer at 1-800-TOP-FARMER extension 129. Ask for Bryan Doherty.
Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.