By: Costas Bocelli — November 13, 2019
I can assure you that our team reads each and every one of them.
And we thank you for all of your feedback, questions and comments. We are here to be a valuable resource in helping you achieve all of your investment goals.
So today, we're going to dive into the mailbag and address a reader's request to discuss a hedging strategy that can be applied to protect against another market downturn.
This comes from Robin J. from "across the pond":
The stock market has made a big run during the past several weeks. Now with many short-term indicators that I follow flashing "overbought", could you please run through an example of how to protect a portfolio of US stocks against downside risk...
...as I'm not an option expert, as much detail as possible, please.
I thank you Robin for writing in.
And while we cannot give personalized investment advice, Robin brings up a valid concern that many of our other readers share.
All the US major stock market averages have rallied strongly in 2019.
The S&P 500, the primary US benchmark, has gained roughly 23% year-to-date.
But the ride to all-time record highs has been a bumpy one.
You see, since the winter correction lows in late-December 2018, the stock market (S&P 500) has made three meaningful pullbacks.
(Click any image to enlarge)
In May, the S&P 500 pulled back seven percent…
In August, it pulled back six percent...
And in September, another five percent decline.
So here we are, approaching 3,100 in the S&P 500 with many of the short-term trading indicators flashing “overbought”.
For those investors looking to protect against downside risk, now’s the time to grab some insurance.
And here’s the good news…
…it’s on SALE!
In other words, options premiums are relatively low right now, which means reaching for downside protection is a good deal for those that feel concerned.
And here’s the added kicker.
If you structure the hedge properly, you can protect a portfolio of stocks through the third week of March of 2019.
Now you may ask, “why out to March?”
The answer has to do with politics.
No, not whether Trump will be impeached or not. Tune that nonsense out.
It all has to do with the Democratic primaries and “Super Tuesday”.
You see, on Tuesday, March 3rd, 2020 the greatest number of U.S. States will hold their primary elections. More delegates to the presidential nominating conventions can be won on Super Tuesday than any other single day of the primary calendar.
So that means by early March investors should have a good sense of who will likely emerge as the Democratic nominee to challenge Trump in the general election in November.
And some analysts believe that if Elizabeth Warren emerges as the challenger, the stock market will plunge.
Whether that scenario is accurate or not, the point is that there is a cloud of uncertainty as the political process plays itself out.
One step investors can take is to spend a small portion of the portfolio value and grab some downside protection.
How to Grab Election Insurance by Creating a Portfolio Hedge using ETF’s (In Five Easy Steps)
Here’s how it works…
Let’s say you own a portfolio of stocks broadly exposed to the U.S. stock market. And let’s say the current value of the portfolio is $250,000.
As the major stock market averages (i.e. S&P 500, Nasdaq Composite) fluctuate, so does the value of the portfolio.
In other words, there is a general correlation between the stock market and the portfolio.
In this case, we can create a hedge that protects the portfolio from declining in value by purchasing protective Put options in an exchange traded fund that’s tied to one of the major stock market averages.
The first step is to select which ETF you will use to create the hedge.
Since we have a broad exposure to U.S. Equities, we could buy Put options in the SPDR S&P 500 ETF (SPY).
The SPY is tightly correlated to the performance of the S&P 500 index.
The second step is to identify the price of the ETF. It's currently trading $309.00 per share in our example.
The third step is to determine the notional value of the 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 $30,900.
The fourth step is to divide the amount to be hedged by the notional value.
This calculation determines how many Put option contracts to purchase.
Since the portfolio value is $250,000, we’ll divide it by $30.900 which equals 8.09
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 simply round to the nearest whole number which is eight Put option contracts in this example.
Finally, the fifth step is to locate the appropriate protective Put option to buy (strike price and 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 90 days until it expires.
But since we want to capture Super Tuesday on March 3rd in the hedge, we’re going to go out a bit further in time. (March expiration is 127 days from today)
In this example, you could look to buy eight SPY March 305 Puts that will cost $9.00 each or $900 per contract with SPY trading around $309.00 per share.
That means, to create a hedge that will protect a $250,000 portfolio we’ll spend $7,200, or about 3% of the value, for unlimited downside protection between now and March expiration (March 20, 2020).
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, often it is adequate and at the same time greatly reduces the hedging cost.
In our example, you could look to sell the SPY March 273 Put options for $3.00 each or $300 per contract and reduce the overall cost of the hedge from $9.00 to $6.00, which offers a 33% discount.
The limited protection effectively covers a selloff in the S&P 500 down to 2,730 or a 10% decline. That level also happened to be the May correction low earlier this year and would likely be a major area of support should it come to that (red arrow).
Portfolio hedging using options is an effective means for managing risk for those investors that own a basket of securities.
It’s also another shining example as to the benefits of options investing.
And speaking of benefits... If you didn't get a chance to join "Big Bill" Spencer at his Technology Crossroads event earlier this week, no worries.
We recorded the entire presentation. You can check it out here.
Time after time, the kinds of technology “crossroads” that Bill revealed have turned small investments into massive profits.
So do yourself a HUGE favor and spend a few minutes today hearing what Bill had to say.
Until next time!