The U.S. federal reserve Board’s interest rate game is coming dangerously close to overshooting its mark of slowing inflation expectations and an overheated real estate market without crushing the U.S. economy in the process. As a result, we are now in a grey area in which a stand-pat interest rate solution may give rise to inflation — and in which a continued rate-hike policy may choke economic growth.

In addition, we cannot overlook the impact that potential supply disruptions from terrorists trying to wreak havoc on the oil markets could have on the stability of Western economies. The result is that Canada, which is seen as a stable supplier of energy, becomes an attractive place to invest, whereas a country such as the U.S., which looks for stable supplies, is a more difficult market in which to build an investment scenario.

That confusion plays out every day as the U.S. stock market ebbs and flows, seemingly stuck in neutral. This is in spite of an underlying economy that, from all appearances, is running full out. U.S. GDP growth is expected to come in between 3% and 4% this year, and unemployment to remain below 5%.

For advisors, that presents a classic fence-sitter’s dilemma. An advisor trying to make an educated guess about the impact of the Fed’s next moves will feel like a deer caught in the proverbial headlights. Economic scenarios that range from growth to stagflation to chaos (avian flu or major terrorist attacks, for example) are as difficult to predict as the flight path of a falling leaf in a windstorm.

What is interesting, given this macroeconomic backdrop, is the complacency in the markets. The volatility index, which measures the level of option premiums on the Standard & Poor’s 500 composite index, closed at 11.46% in early March. That value is well below the 200-day moving average of 12.55%, which in and of itself has been trending lower for the past couple of years.

Such complacency among investors suggests most believe there is very little risk in the markets. Often, market sentiment is dead wrong at exactly the wrong time. In hindsight, we can look back and see that such was the ideal time to buy protective puts.

I am not usually a fan of buying puts. Typically, I advise investors who are not comfortable with a particular stock, or who do not like the outlook for the market, to exit their position and move to cash.

However, with option premiums at such low levels, the cost of “put insurance” is not high, making the protective put an interesting alternative. The trick is understanding the cost of protection clearly.

To evaluate that cost, the advisor should take the premium less the deductible and divide that by the current price of the underlying stock. The deductible is simply the amount by which the option is in the money or out of the money.

As an example, let us examine the cost of options on the Nasdaq 100 Tracking Shares (symbol: QQQQ). At the time of writing, the QQQQ was trading at $41.45 (all prices are in U.S. dollars). The QQQQ January 42 puts (with 322 days to expiry at time of writing) were trading at $2.40 a share.

If the option is in the money, as is the case in our example, we would subtract the in-the-money amount (the deductible) from the total premium to ascertain the pure cost of protection. If the option is out of the money, we would add the out-of-the-money amount to the premium and divide that by the price of the underlying stock.

In our example, the option premium is $2.40 a share. The option has a $42 strike price and the underlying stock is trading at $41.45. In this case, the QQQQ option is in the money by 55¢, which is deducted from the total cost of the premium ($2.40 minus 55¢ equals $1.85). Thus, the pure cost of protection is $1.85 a share. When we divide that number by the current price of the underlying stock ($41.45), the cost of protection is 4.46%.

Finally, we take the total premium and divide by the number of days (you can also use weeks or months as your base time period, depending on which gives you the most comfort) to determine the cost per unit of protection. In the table above, we use “days to expiry” to calculate the cost per day of insurance.

@page_break@The table above examines two strike prices on the QQQQ and two close-to-the-money strikes on Dow Diamonds (symbol: DIA; listed on the American Stock and Options Exchange). Dow Diamonds is an exchange-traded fund designed to replicate the Dow Jones industrial average. In this analysis, we examine the cost of protection from two points: on the basis of the percentage cost of protection and on the basis of the cost of protection in cents per day.

So, if you are buying protective puts, you should examine the available choices in much the same way as you would buy car insurance: according to the length of the term (i.e., expiry date), the amount of the deductible (i.e., strike price) and the cost. IE