All the talk lately is about the much belated return to 5,000 on the Nasdaq, a level not achieved since just prior to the bursting of the Internet bubble in 2000. The tech-heavy index has risen about 15% over the past year and has jumped more than 100% over the past five. 

Now shares of the companies in the index trade for 31 times trailing earnings, a premium of 67% to the valuation of the stocks in the S&P 500. You can’t help but wonder if the Nasdaq is in for another tumble.

To be fair, things are not the same as they were in 2000. Back then, the index reached a valuation of 175 times trailing earnings and startup tech companies dominated the price action. Today, tech companies make up just 55% of the largest 100 companies in the index, followed by consumer stocks (27%) and health care (14%).

But just because it’s not an obvious bubble does not mean we can sound the all clear.

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The Bubble Chorus Grows
Some notable investors have joined a growing chorus that may not yet be screaming, “Bubble!” but is definitely worried about valuations getting lofty. 

Bond king Bill Gross of Janus Capital recently told CNBC that Nasdaq 5,000 represented “a little bit of a bubble,” and that negative interest rates globally may have skewed the way financial markets work, causing a mindless rush into stocks. 

Nobel laureate Robert Shiller updated his book, “Irrational Exuberance,” this month, pointing out that “evidence of bubbles has accelerated since the crisis.” Billionaire Mark Cuban also chimed in, saying the current bubble in private companies and startups is worse than the tech bubble of 2000, putting the economy at risk.

Since the Nasdaq is market cap-weighted, larger companies make up a larger portion and can significantly affect the headline number. Shares of Apple (NASDAQ: AAPL), for example, now make up 10% of the index and trade at 17.1 times trailing earnings compared with a five-year average of 15.4. 

Enthusiasm is at a peak for new products with the iWatch scheduled for an April release. What happens if it fails to live up to the hype? And the next iPhone release is rumored to be this fall, but those are just rumors, and we all know what happens to shares of this tech giant when its product cycle stagnates.

But selling all your Nasdaq-traded stocks is certainly not the answer. Throwing the proverbial baby out with the bathwater means you’ll be selling some great value plays.

So the question becomes, how do you protect yourself from a bubbly Nasdaq without shunning good names in the index?

Paying for Protection
Options can be a great tool for protection. Buying put options on a stock or an index is often referred to as “buying portfolio insurance.”

Because a put option gives you the right to sell shares of the underlying at a specific price, called the strike price, it functions as a hedge against a large drop. The strategy will cost money and moderate your returns if prices keep moving higher, but it is a godsend if the worst-case scenario plays out.

Buying put options on an index ETF to protect against losses in specific stocks carries an added benefit. Since the ETF is likely much less volatile than a single stock, the premium on the put options will be lower.

There is no ETF that tracks the entire Nasdaq index with sufficient liquidity, but we can use the PowerShares QQQ Trust (NASDAQ: QQQ), which tracks the 100 largest companies in the Nasdaq and currently trades for 22 times trailing earnings. 

The Nasdaq 100 has actually outperformed the larger index by about 5 percentage points with a return of 19% over the past year. Apple makes up 14.6% of the fund, followed by Microsoft (NASDAQ: MSFT) with 7%, Google (NASDAQ: GOOGL) with 3.9%, Facebook (NASDAQ: FB) with 3.6% and Amazon.com (NASDAQ: AMZN) with 3.5%.

With QQQ trading for $107.41, we can buy QQQ Sep 105 Puts for $4.63 per share ($463 per contract). This gives us the right to sell QQQ for $105 on Sept. 18 with a breakeven price of $100.37 ($105 strike minus $4.63 options premium), which is 7% below current prices. 

For portfolio protection, I like to buy options at least six months out to protect myself over a couple of quarters. I usually devote 3% of my portfolio to insurance. For example, if you have a $100,000 portfolio, then you would buy $3,000 worth of put options.

If the ETF closes above $105 on expiration, our puts expire worthless but we should show gains on the rest of our portfolio. If QQQ closes below $105 on expiration, we collect the difference and that gain can help to offset any losses in our portfolio.

If QQQ were to fall by 10% to $96.67 by expiration, we will make $8.33 per share ($105 strike minus $96.67) for an 80% return. 

As we pass the six-year anniversary of the March 2009 market trough, you might want to think about protecting yourself.

I’m far from alone in my concerns that stocks may be overextended. My colleague, Jared Levy, believes the next two weeks are a crucial time in the stock market. 

He has developed a unique trading technique that helped him minimize risk without compromising gains — and allowed him to retire from Wall Street by the age of 23. He recently sat down with our publisher to explain how he has used it to close trades that made 70% in 11 days… 123% in six weeks… 58% in six days and 129% in two months. 

If you want to hear his take on the uncharted market territory we find ourselves in — and how he is applying his unique trading approach — follow this link.

This article originally appeared in ProfitableTrading.com: How I’m Protecting Myself From a Nasdaq Bubble​