Volatility’s Perfect Storm

First, public satisfaction was the highest since the summer of 2007. Every bailout and new government program reinforces the warm and fuzzy investor psychology that allows us to believe that everything will be fine. A volatility index measures the cost of protecting your stock portfolio by purchasing put options. Put options are similar to buying portfolio insurance. If you hedged your $300,000 stock portfolio, it would cost you a put premium of about $8,500 to protect the entire value of the portfolio from any downside risk through June. The same insurance policy would cost $23,625 in the afternoon. Assuming the value of your portfolio equals the stock market decline, you would lose 3.25% on your $300,000 or $9,750. The difference between the $8,500 paid up front versus the current portfolio value of $290,250 plus the current value of the insurance policy of $23,625 means that on the day of the stock market’s biggest point loss your net worth…

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