When I was exclusively in the stock market, the only way I knew to protect my long-term holdings was to buy puts.
That way, I wouldn’t have to cause a taxable situation with the bulk of the holdings and didn’t have to worry about timing the re-entry back into the market either.
However, with put options, you are charged a commission to buy them and usually another commission to sell them. That’s in addition to your spread costs.
Also, they expire. So they only cover you for a limited amount of time. Then you have to do it all over again — pay more commissions, more spreads, and so on.
It’s a costly insurance program of sorts, but it is one way to accomplish this.
Now, when I came over into the forex market, I learned about what I believe to be a better way of doing this.
There are currency pairs that you can sell with little money down yet you’re controlling a bigger position just like you had in the option, except that you don’t have any of the buy or sell commissions. You simply have the one spread cost.
Also, since these forex positions don’t expire like an option contract you don’t even have to open new positions and incur extra spread costs.
So it’s a better way to protect your portfolio from the downside of the market because you cut out the extra costs and the need to continually buy more contracts as the old ones expire.
Less time involved, less money spent equals a better way to protect your portfolio.
Which currencies respond well as stocks tank? Mainly, the yen and the U.S. dollar.
So you can short pairs like EUR/JPY, GBP/JPY, or GBP/USD, for instance.
As money flows out of these other currencies back into the dollar and yen (since they serve as good defensive plays), the gains that you get from initiating sells (shorts) on these pairs help to offset some of the near term losses that you would incur in your stock portfolio.
Therefore, the next time you go to defend your stock portfolio against a downward spiral in a recession or severe correction, look to the spot FX (forex) market. The spreads are small. Enjoy no commissions and no “constant buying” of option contracts.
In the end, it’s a cheaper and more convenient way to protect your portfolio.
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