By: Costas Bocelli — December 20, 2018
Are we headed for the next Great Depression?
If you look to the price action in the major stock market averages this month, maybe so.
You see, December is supposed to a bullish time for stocks. But not this year, at least through the first half of the month.
In fact, the S&P 500 and the Dow Jones Industrial Average are on track to post the worst December since 1931. The Great Depression happened to be the worst economic downturn in the history of the industrialized world. Worse, it endured for more than a decade.
Are things as bad today as they were back then?
Of course not. With a strong labor market and low inflation, corporate profits at record highs and economic growth running above trend... it'd be ludicrous to compare the current economic environment to that of the Great Depression.
That said, it's still the case that the stock market is in the throes of a pretty nasty correction. In fact, since stocks began to sell off in early-October, things have gone from bad to worse as the holidays approach.
Earlier this week, all the major stock market averages were in correction territory (declines of greater than 10% from their previous peaks), something that hasn’t occurred since March 2016.
Last week, we we’re peering into the winter sky, looking for Santa’s sleigh to swoop in and rally the bulls. We argued that stocks were poised to rally.
Well, here’s the thing…
Today stocks are even more oversold, sentiment is more excessively bearish... and all of our internal breadth indicators look washed-out. In other words, the odds of a strong rebound, at least in the short-term, are very high.
The major stock averages stand at a pivotal inflection point -- a technical level of support which, if broken, could send the market significantly lower.
Have a look at a two-year daily chart of the Dow and you’ll see that it’s sitting on a major level of support.
(Click to enlarge image)
And while the odds may favor a strong bounce from “oversold”, a breach of this level could easily spark a panic, sending the Dow lower another 2,000 points (or more).
As the holidays approach, liquidity is drying up. And with the high frequency “algo’s” accounting for most of the trading volume these days, it could be a real “bloody Christmas” for investors should that support level fail.
With that in mind, there’s a way investors can stay long the market while protecting their portfolio from another potential leg lower. That means you can spend less time worrying about the market, and more time enjoying the holidays with your family.
The hedging technique is called a portfolio hedge and it's very easy to apply. Think of it as the perfect gift that you can give to yourself and your nest egg this holiday season.
By purchasing Put options in an exchange traded fund (ETF) that is highly correlated to the moves in the stock market... you can hedge an entire basket of stocks in your portfolio.
If you think about it, the value of your portfolio typically rises when the stock market rises, and typically declines when the stock market falls. So why not create one hedging trade in an ETF that tracks the movement of the entire stock market?
Take the SPDR Dow Jones Industrial Average ETF (DIA) for example. This ETF is highly correlated to fluctuations in the Dow. So if you’re portfolio typically tracks the price moves in the Dow, you can look to purchase Put options in the DIA.
How To Create A Portfolio Hedge
Here’s a five-step method for protecting a basket of stocks with a market value of $100,000.
Step 1: Select the ETF that is most correlated to the basket of stocks you want to protect. In this example, we are using the SPDR “Dow” ETF (DIA).
Step 2: Identify the price of the ETF. In this example, the DIA is trading $237.36 per share.
Step 3: Determine the "notional value" of the hedge. Since each Put option controls 100 shares of the ETF, we need to multiply the price of the ETF by 100 which equates to $23,736. That’s the notional value.
Step 4: Determine the number of Put options you need by dividing the value of your portfolio by the notional value. In our example, divide $100,000 by $23,736 -- which equals 4.21.
Since we can’t purchase a fractional options contract, round to the nearest whole number which means we should look to purchase four Put option contracts.
Step 5: Target the most appropriate Put option to buy. As a rule of thumb, look to purchase the Put option with about 90 days to expiration, and slightly out-of-the-money. That means, choose the Put option with a strike price just below the price of the ETF.
In our example, with the DIA trading $237.36, we can look to purchase four DIA March 235 strike Put options which can be purchased for $9.25 each, or $925 per contract.
Since we are purchasing four Put option contracts, the cost to hedge the entire portfolio is $3,700 which represents 3.7% of the value of the securities held. If the market takes another dive, our Put options will gain in value and roughly offset any losses we'll likely incur.
Now, hedging always comes with a cost, just like purchasing home or car insurance comes with a cost. The good news is: there are ways to substantially lower the cost of our hedge without sacrificing adequate downside protection.
But that, as the man said is another story...
Trade safely through the holidays and I’ll see you soon.