By: Costas Bocelli — May 14, 2020
Time to Hedge? Here’s How to Do It…
The bear market rally has been impressive.
Take the S&P 500, the primary benchmark index for U.S. Equities.
It’s gained more than +34% since making a low of 2,191 back on March 23rd.
Recently, the S&P 500 has traded up to the 2,933 level.
(Click any image to enlarge)
It did so in late-April, and again earlier in this trading week. But we now see sellers re-emerging and the forces of supply gaining strength.
And it’s no coincidence that the rally is being repelled at or around 2,933 in the index. Why?
It’s because 2,933 represents a significant price point. From the February peak to the March trough, this level represents a 61.8% retracement of the decline.
Fibonacci Retracement levels are often used to indicate horizontal lines of support or resistance that are likely to occur. And a 61.8% retracement is a doozy!
As we mentioned, the S&P 500 has rallied more than +34% off of the lows. The index is market-cap weighted. So stocks that carry a higher market-capitalization hold more influence than stocks that have a smaller market-capitalization.
And let me tell you that the majority of the gain in the S&P 500 has come from just a handful of stocks. I’m talking about the mega-cap stocks, often referred to as the “Generals” of the stock market.
Think Apple (AAPL), Amazon.com (AMZN), Microsoft (MSFT) and Alphabet (GOOGL) and you’re on the right track.
Each of these four companies has a market-cap in excess of $1 trillion.
It’s these four stocks and a handful of other large-cap growth stocks from the Technology sector that are responsible for most of the heavy lifting off of the March lows.
To put it in perspective, have a look at the performance of the Nasdaq 100 ETF (QQQ) to that of the Russell 2000 ETF (IWM) since the start of the year.
The Russell 2000 index is comprised of small-cap companies. Most of the companies have a market capitalization under $3 billion. These small-cap stocks are often referred to as the “soldiers” of the stock market.
Typically, in a healthy advance you’d find the soldiers leading the bulls into battle. But it’s been quite the opposite with this advance. Here we find the Generals doing the bulk of the fighting on the front lines.
While many stocks have moved well off the lows, there are plenty of reasons to be worried about the short- to medium-term outlook.
Investors looking for ways to grab some downside protection can use a hedging technique to mitigate downside risk.
I think for the major stock market averages to suffer another significant selloff, we’ll likely need to see the blood of some of these Generals spilled on the battle field.
Since these were the ones that led the market up, then it’s highly likely these would be the ones to pull it back down.
With that in mind, we could look to construct a hedge that’s predicated on a potential selloff of large-cap Technology stocks.
Since Technology is the strongest broad sector in terms of relative strength, equity portfolios should have a healthy weighting of technology-oriented stocks.
So we could look to construct a portfolio hedge that targets the Nasdaq 100 ETF (QQQ).
This would be a useful exchange traded fund in the event that we begin to see some of these Generals getting whacked on the field of battle.
That’s because these four stocks (AAPL, AMZN, AAPL, and GOOGL) comprise more than 40% of the entire weighting of the QQQ ETF.
Here’s how it works…
How to Create a Portfolio Hedge Using ETF’s (In Five Easy Steps)
Let’s say you own a portfolio of stocks broadly exposed to the U.S. stock market, or, what's better, a portfolio overweighted in Technology stocks.
And let’s say the current value of the portfolio is $250,000.
If you follow these five easy steps, you can easily create a hedge.
Step #1 is to select which ETF you will use to create the hedge.
Since we are targeting the mega-cap Technology stocks, we’re going to focus on the Nasdaq 100 ETF (QQQ)..
Step #2 is to identify the price of the ETF.
Early Wednesday morning (at the time of this writing), the QQQ was trading $223.50 per share.
Step# 3 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 $22,350..
Step# 4 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 $22,350 which equals 11.18
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 Eleven Put option contracts in this example.
Finally, in Step #5 we locate the appropriate protective Put option to buy (the strike price and expiration date).
At True Market Insiders, we advocate hedging with a Put option that is at-the-money or slightly out-of-the-money and has about 90 days until it expires. That's the "sweet spot".
In this example, you could look to buy 11 QQQ August 220 Puts. At the time of this writing yesterday morning, and with QQQ trading around $223.50 per share, each Put option would cost $12.60, or $1,260 per contract.
That means we’d need to spend $13,860 (or 5.5% of the portfolio value) to create a hedge that will protect a $250,000 portfolio that offers unlimited downside protection over the next 100 days. (The Put option contract expires August 21st, 2020).
Typically, you should look to spend no more than 3% to hedge the portfolio. But with market volatility relatively high, the cost of option premiums is high as well.
In other words, hedging against downside risk is very expensive.
Luckily, you can reduce the cost of the insurance by selling a lower strike Put option, thus creating a Put Spread.
While this action offers limited downside protection, often you’d find that it can still provide substantial protection for a fraction of the cost.
In our example, you could look to sell the QQQ August 195 Put options for $6.00 each (or $600.00 per contract) and reduce the overall cost of the hedge from $12.60 to $6.60 -- a 48% discount.
The limited protection effectively covers another potential selloff in the NDX 100 ETF (QQQ) down to 195.00 (an 11% decline). That level also happens to be below the 200-day moving average (red line in the image above) which has served as longer-term support, albeit one that was briefly violated during the capitulation phase of the March selloff.
Portfolio hedging using options can be an effective means for managing risk for investors owning a basket of securities.
And for those that think the broad market is at risk of another selloff, look to the “Generals” that are susceptible of falling on their swords.
Until next time!