By: Costas Bocelli — October 2, 2019
And he wasted little time; the warning arrived on the very first trading day of the month.
On Tuesday, October 1st, all three major stock indices suffered broad declines.
The Dow Jones Industrial Average dropped 343 points or -1.3%, wiping out all of the gains in the third-quarter.
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Markets dropped following the release of the manufacturing business index from the Institute of Supply Management. The report showed that in the month of September, factory activity shrunk at the fastest pace in ten years.
The 47.8 reading revealed the second consecutive month of contraction (below 50) and the weakest result since June 2009.
The ISM Manufacturing Index is considered a leading indicator of economic health. And investors apparently rushed to conclude that an economic recession is right around the corner.
But we’ve seen these recession fears before. Remember the yield curve inversion in the U.S. Treasury bond complex during the stock market correction in August?
Stocks managed to rebound in September and move back towards their July highs, which still remain a formidable level of resistance.
But there’s still plenty more to worry about during the month of October:
U.S. – China trade uncertainty remains a serious concern. High-level trade talks are scheduled for October 10-11th in Washington D.C., but it’s anyone’s guess how much progress, if any, will be made.
Also, third-quarter earnings season is set to begin the week of October 14th when the big money center backs report results. Analysts are forecasting an earnings decline for the S&P 500 of -3.7%. If true, it will be the third straight quarter of year-over-year earnings declines.
Oh, and let’s not forget that the Democratic controlled House of Representatives is hell bent on kicking President Trump out of the White House. Last week, the House launched a formal impeachment inquiry against Trump alleging collusion with a foreign leader(s) and election interference.
So there you have it.
October is set up to take investors on a wild ride…
…and where is goes, nobody knows.
But the good news is that you can ride out the volatility storm and protect your nest egg against downside risk by making one simple move.
You’ll be able to maintain all of your upside as well, should stocks break out to new highs.
Remember, volatility cuts both ways. In other words, we could also see one of those “rip your face off rallies” that’s equally painful to those betting against the market.
When the Dow Jones Industrial Average closed at 26,573 on October 1st, the index was less than 3% from an all-time high and was trading in the vicinity of its 50-day moving average.
Investors worried that the market is prone to a significant selloff can spend a small portion of their portfolio value and purchase an insurance policy. And we can do this by making one simple trade using an exchange traded fund (ETF).
So whether you’re an investor who owns a few mutual funds…
…or one with a sizable portfolio of stocks, we can protect nearly every composition by implementing just one options trade.
How to Nip Volatility in the Bud with One Simple Move (In Five Easy Steps)
Here’s how it works…
Let’s say you have a portfolio of stocks, mutual funds and other securities that are broadly exposed to the U.S. stock market.
And let’s say that the current value of the portfolio is $150,000.
As the major stock market averages fluctuate, so does the value of the portfolio.
In other words, there’s a general correlation in the performance of the stock market and your portfolio.
In this case, we can create a hedge that protects the portfolio. We just need to purchase protective Put options in an ETF tied to one of the major market averages.
Step One is to select which ETF you will use to create the hedge.
Since we have broad exposure to U.S. Equities, we could buy Put options in the SPDR Dow Jones Industrial Average (DIA). The DIA closely tracks the performance of the Dow Jones Industrial Average.
Step Two is to identify the price of the ETF. In our example DIA is trading $265.50 per share.
Step Three is to determine the "notional value" of our hedge.
To determine the notional value, multiply the price of the ETF by 100, because each Put contract represents 100 shares in the ETF.
In our example, the notional value is $26,550.
Step Four is to divide the amount to be hedged (the portfolio value) by the notional value. This calculation determines how many Put option contracts to purchase.
Since the portfolio value is $150,000, we’ll divide it by $26,550 which equals 5.65. That is the number of protective Put option contracts needed to ensure the proper amount of downside protection.
Since we can’t buy a fractional option contract, we’ll have to either round down and buy five contracts or round up and buy six contracts.
Step Five is to locate the appropriate protective Put option to buy, meaning choosing the strike price and the expiration date.
At True Market Insiders, we advocate the hedging “sweet spot” to be a Put option that is at-the-money or slightly out-of-the-money and has about 3-months until it expires.
In this example, you could look to buy six DIA December 265 strike Puts that cost $8.25 each or $825 per contract with DIA trading around $265.50 per share.
That means, to protect a $150,000 portfolio, we’ll need to spend $4,950 or about 3% of the value, for unlimited downside protection between now and December 20th, the expiration date.
There are also ways to reduce the cost of the hedge, such as selling a lower strike Put option and creating a Put spread.
While this offers limited downside protection, it is often perfectly adequate, and at the same time greatly reduces the hedging cost.
Referring back to our example, you could look to sell the DIA December 245 strike Put option for $3.15 each ($315 per contract) and reduce the cost of the hedge from $8.25 to $5.10, a 38% discount.
The limited protection effectively covers a selloff in the Dow Jones Industrial Average down to 24,500, or a decline of 8% from its current level. That level also happens to line up with the May correction low and likely will be seen as significant support.
With volatility likely to ratchet up in October, reaching for some insurance protection over the next few months may be money well spent.
Portfolio hedging using options can be an effective strategy to manage risk for investors that own a basket of securities.
In Options Soup, our options educational program, we show investors exactly how to protect individual stocks and an entire portfolio using Put options and Put spreads. To learn more about Options Soup, call 855-822-0269 or email us at firstname.lastname@example.org
Until next time!