Cover Story: Midyear Investment Outlook

401(k)s: A SAFETY NET FOR YOUR NEST EGG

Put options aren’t for everybody. But they’ll pay off nicely if the market tumbles

You’re sitting on huge gains in your 401(k), you’re close to retirement, and you’re worried that something—Indonesia, India, Alan Greenspan—is about to make stocks crash and splatter your nest egg all over the sidewalk. You could diversify your holdings better or move entirely into cash. But let’s say you want to hang on to the portfolio you have because you don’t want to miss any upward moves the market may have in store. Some investment counselors suggest laying on some crash insurance—namely, put options.

Put options aren’t for everybody. The best candidates are sophisticated investors nearing retirement who have substantial 401(k) holdings—and enough cash on hand to spend on options that will very likely expire worthless. Their main attraction is that they let you stay in the market with the stocks you like, secure in the knowledge that you can’t be wiped out if the Dow Jones industrial average heads south. The alternative is to exit the market, which could be expensive if you’re wrong, says Michael Schwartz, chief options strategist at CIBC Oppenheimer Co. This way, you can use some of the 40% or 50% returns you’ve earned lately to buy some protection.

The vehicle recommended by several strategists for hedging a diversified 401(k) stock fund is put options on the Standard & Poor’s 500-stock index. (You’ll need to hold the puts in a separate account, because most 401(k) plans don’t permit accounts to hold options.)NOT CHEAP. An index put option gives you the right to sell an index contract at a preset price (the strike price). The option can be exercised any time up to its expiration date. When the index goes down, the option to sell at the preset price increases in value. Thus, your profit on the put would offset the losses in your 401(k).

Be aware that options aren’t cheap. To hedge a $200,000 portfolio through the end of 1998 could cost about $10,000 (table). Protection can stretch to three years with long-term equity anticipation securities (LEAPS). Those contracts cost more: as much as $9,000 to protect $100,000 through December, 2000. To reduce hedging costs, you can buy a put that’s a little out of the money. This means that the options’ strike price is below the index value, so the first part of a decline is unhedged.

According to Kevin Murphy, managing director of Salomon Smith Barney’s retail options department, here’s how you might use puts to hedge $200,000 in diversified stocks in a 401(k) from now through December: Each put option hedges about $100,000, so you would need to buy two. At the S&P’s recent level of 1086, Murphy recommended buying a 1050 put, which was about 3% out of the money and cost $4,950. If the market fell 20%, to 869, each put would be worth $18,100. You are down $40,000 on your portfolio, but the value of the puts is $36,200, less the $9,900 you spent on them. That gives you a profit of $26,300, offsetting most of your $40,000 loss.

Conversely, if the market climbed 20%, the puts would expire worthless. But you would have made $40,000 on your portfolio. Less the $9,900 you spent on the hedge, you are up $30,100.

If that much insurance strikes you as too expensive, you could hedge only half of your holdings: Buy one put, not two. After all, you’re looking at this as a hedge, not to make a profit, says Scott H. Fullman, chief options strategist at Swiss American Securities Inc.

One problem with puts is paying taxes on any profits you make on them. That’s now a nice gain in your own individual account and not your retirement account, says Stewart Winner, director of retail options sales and trading at Prudential Securities Inc.

For most people, Winner recommends getting out of the market instead of using puts. You’re trying to put a Band-Aid over a bigger problem, agrees John Markese, president of the American Association of Individual Investors. Maybe so. But for people who just can’t bear to part with the 401(k) portfolio they’ve so carefully assembled, put options may be a way to ease the angst over the market turbulence that surely lies ahead.By Amey Stone in New YorkReturn to top