A Bit of Protection Could Yield Large Profits If the Market Swoons

I do not trust this market. While deals are starting to pop up in the energy space after a sell-off in crude, the rest of the market is getting expensive, and the slightest hint of weakness seems to send it down. 

Take October, for example. No sooner had third-quarter earnings started than the market went into a tailspin, falling nearly 8% before starting its recent rebound. 

Some nervousness and profit-taking is to be expected after more than five years of a bull run, but there was really no reason for the market to sell off. Earnings promised to surprise as the U.S. economy zipped higher. Sluggish growth in Europe had been an issue for more than a year, and the Ukraine conflict was still just simmering. 

When even a strong earnings season fails to keep stocks from swooning, you know market valuation is getting stretched. When this happens, I start looking to protect my portfolio from the next bout of irrational selling.

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The traditional method of put option buying for protection involves a bet that the shares I hold are on their way lower. But I like the stocks I have in my portfolio; it’s the market I’m worried about.

Furthermore, buying puts against the market is expensive, and I’ve got a better strategy. It involves betting against a company with weak fundamentals and too high of a price tag.

I recently sold my four-year position in shares of Intel (NASDAQ: INTC) after the huge move this year. It was sometimes tough, but I held the shares when everyone else said chips were dead money and that no one would make money until the industry shook out its weakest players. I agreed that the industry was in bad shape, but I had faith in this chip giant. 

From the beginning of 2012 through the first five months of this year, shares of Intel yielded a rate of just 6% on an annualized basis. It was only during the past five months that it surged, rising more than 30%. 

What has changed over the past five months? Not much, really. Global growth remains weak outside the United States and margins are still under pressure from competition. 

The only thing that changed was the market’s attitude toward semiconductors. 

If market sentiment turns sour again, I think wobbly semiconductors will get hit the hardest. That is why I am using one of the weakest players in the space as my portfolio protection stock.

Broadcom (NASDAQ: BRCM) is up about 40% this year and nearly 12% since it reported third-quarter earnings on Oct. 21. Investors cheered when the company beat expectations and finally showed a year-over-year sales increase after three straight quarters of declining revenue growth.

Shares are trading near their 52-week high and just 13% from their five-year peak. The price multiple of 57 times trailing earnings is more than twice the industry average of 22, according to Morningstar. 

What drove the beat in sales and strong earnings?

Revenue from Apple (NASDAQ: AAPL) and Samsung was up 35.7% over the previous quarter and accounted for nearly a third (29.9%) of all revenue compared with 24.4% in the prior quarter. The new product cycle for Apple drove much of this as people lined up to get their new iPads and iPhones. 

But the company will be hard-pressed to keep that momentum in sales as the Apple product cycle ages. The company, and exuberant investors, seems to be pinning its hope on one customer.

Protect Yourself Without Having to Bet Against Your Winners

The protective put strategy involves buying put options against a stock position to guard against a large drop in the shares. You pay a premium but are totally hedged beyond a certain price. 

The strategy is usually done with a stock you hold or with puts against the entire market. But I like the stocks in my portfolio, and the market may not sell off enough to make it profitable.

Weak fundamentals and a lofty valuation make BRCM an excellent substitute to bet against. As you can see in the chart, when the market sold off sharply, the semiconductor stock took it hard. When the S&P 500 swooned 8% in the first half of October, BRCM fell nearly twice as far with a 15% drop.

BRCM Stock Chart

Today, I’m interested in buying the BRCM Jan 40 Puts with a limit price of $1.

The breakeven is $39 ($40 strike price minus $1 option premium, which is 7% below current prices.

I keep my portfolio protection to about 2.5% or less of my portfolio value so I do not constantly eat away at returns. For example, I can buy 25 BRCM put contracts for $2,500 against a $100,000 portfolio.

If the shares are above $40 at expiration on Jan. 17, I lose the premium but will likely have benefited from appreciation in my overall portfolio.

If the market finds the current euphoria short-lived and falls, then BRCM will likely fall faster and further. With shares around $42, if they were to fall by 10% to $37.80, then the put option would be worth $2.20 per share ($2,200 per contract) for a return of 120% in just two months. Better still, if I bought 25 contracts, I would make an additional $3,000 on a move to this level, helping to offset any losses in my portfolio.