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. 3 TheAftershockInvestorReport.com Special Report 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 Special Report Moneynews.com 4 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. 5 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. TheAftershockInvestorReport.com Special Report 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! Special Report 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 Moneynews.com 6 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 7 TheAftershockInvestorReport.com Special Report 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. The Aftershock Investor Report is a monthly publication of Newsmax Media, Inc., and Newsmax. com. It is published at a charge of $109 for print delivery ($97.95 for digital/online version) per year through Newsmax.com and Moneynews.com. The owner, publisher, and editor are not responsible for errors and omissions. Rights to reproduction and distribution of this newsletter are reserved. Any unauthorized reproduction or distribution of information contained herein, including storage in retrieval systems or posting on the Internet, is expressly forbidden without the consent of Newsmax Media, Inc. For rights and permissions, contact the publisher at P.O. Box 20989, West Palm Beach, Florida 33416. 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 To contact The Aftershock Investor Report, to change email, subscription terms, or any other customer service related issue, email: [email protected], or call us at (888) 766-7542. © 2013 Newsmax Media, Inc. All rights reserved. Newsmax and Moneynews are registered trademarks of Newsmax Media, Inc. The Aftershock Investor Report is a trademark of Newsmax Media, Inc. Disclaimer: This publication is intended solely for informational purposes and as a source of data and other information for you to evaluate in making investment decisions. We suggest that you consult with your financial adviser or other financial professional before making any investment. The information in this publication is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy, sell, or trade in any commodities, securities, or other financial instruments discussed. Information is obtained from public sources believed to be reliable, but is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted. In no event should the content of this letter be construed as an express or implied promise, guarantee or implication by or from The Aftershock Investor Report, or any of its officers, directors, employees, affiliates, or other agents that you will profit or that losses can or will be limited in any manner whatsoever. Some recommended trades may (and probably will) involve commodities, securities, or other instruments held by our officers, affiliates, editors, writers, or employees, and investment decisions by such persons may be inconsistent with or even contradictory to the discussion or recommendation in The Aftershock Investor Report. Past results are no indication of future performance. All investments are subject to risk, including the possibility of the complete loss of any money invested. You should consider such risks prior to making any investment decisions. See our Disclaimer, as well as a list of stocks that the Senior Financial Editor owns by going to TheAftershockInvestorReport.com. Special Report Moneynews.com 8