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By: Costas Bocelli — July 23, 2020

How to Guard Against a Wreck in “Big Tech”

Things appear quiet...

But you can feel the storm building.

Stocks have made a remarkable recovery off of the March lows.

Leading the charge are the big-cap technology growth stocks.

You know the ones…

Microsoft (MSFT)… Amazon.com (AMZN)… Facebook (FB)… Alphabet (GOOGL)Apple (AAPL).

(Click any image to enlarge)

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And since the market bottom on March 23rd, each of these tickers has outperformed the S&P 500, the primary benchmark for US Stocks.

If you’ve been riding the wave of these stocks and other high-growth tech stocks, then you’ve likely seen the value of your portfolio increase substantially.

And with each incremental dollar gain, uneasiness continues to grow.

Technology is obviously the most overbought segment of the market and the most heavily crowded in the marketplace.

Investors piling into high-tech growth have benefited from the bullish momentum.

But one has to wonder:  How much more is left in the tank before we reach buyers' exhaustion?

That’s anyone’s guess.

But let me tell you that the conditions for a “downside correction” are firmly in place.

Let’s just throw out a few of the potential catalysts than can send investors rushing to the exits.

We’ll start with the obvious one.

There’s a raging pandemic virus whipping through large swaths of the United States (and many parts of the world).  With no vaccine and infections on the rise, things could turn very nasty very fast -- like they did in late winter and early spring.

Then there’s rising tensions with China. The U.S. recently announced the closure of the Chinese consulate in Houston allegedly because China had stolen intellectual property and spied on US citizens.

And at the end of the month, many of stimulus programs tied to the CARES Act will stop. The big one is the supplemental federal unemployment insurance payments to those that have been displaced due to the virus pandemic. Unless Congress acts, the market is facing a fiscal stimulus cliff.

Seasonality is another concern.

We’re five weeks from the end of summer and September is typically a bad month for stocks. With 40%+ gain off of the March lows, there's a lot of “air” between now and then.

So does this mean it’s time to bail on stocks?

Not necessarily.

Just look what you’d missed out on if you happened to bail in mid-April… or early-June… or even earlier this month.

Many of the big-tech growth stocks are even higher today!

So jumping ship just as stocks are breaking out to new highs could be a major mistake.

Instead, we could look for ways to maintain bullish exposure while guarding against a potential “wreck in big tech”

That’s what savvy investors do in this type of market landscape.

Investors could look to construct a hedge that’s predicated on a potential selloff of large-cap Technology growth stocks.

One way to go about this is to construct a portfolio hedge that targets the NASDAQ 100 ETF (QQQ).

Why the QQQ?

The five big-tech stocks mentioned above (FB, MSFT, AAPL, GOOGL and AMZN), comprise nearly 50% of the entire weighting of the QQQ ETF.

So if we’re looking for broad protection against a drop in big-cap tech, the QQQ is a well-suited investment vehicle to construct a hedge.

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 big-cap technology growth stocks.

And let’s say the current value of the portfolio is $210,000.

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 guarding against a potential wreck in big-cap tech (stocks), we’re going to focus on the NASDAQ 100 ETF (QQQ).

Step #2 is to identify the price of the ETF.

Yesterday afternoon (at the time of this writing), the QQQ was trading $264.30 per share.

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Step# 3 is to determine the "notional value" of the hedge.

To determine the notional value, multiply the price of the ETF by 100.

The reason is that we're going to be using Put options to build our hedge... and each Put contract represents 100 shares in the ETF.

In our example, the notional value is $26,430.

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 $210,000 we’ll divide it by $26,430 which equals 7.95

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, in Step #5 we locate the appropriate protective Put option to buy (the strike price and expiration date).

At True Market Insider, 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 eight QQQ October 260 Puts. At the time of this writing (yesterday afternoon) with QQQ trading around $264.30 per share, each Put option would cost $13.00, or $1,300 per contract.

That means we’d need to spend $10,400 (or 5.0% of the portfolio value) to create a hedge that will protect a $210,000 portfolio and offers unlimited downside protection over the next 85 days. (The Put option contract expires October 16th, 2020).

Typically, you should look to spend no more than 3% to hedge the portfolio.

But market volatility is relatively high right now -- the VIX is currently 25 versus the longer-term historical average of 16 to 18 -- and so options premium is relatively high as well.

In other words, hedging against downside risk is more expensive.

Fortunately, 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 October 230 Put options for $5.40 each (or $540 per contract) and reduce the overall cost of the hedge from $13.00 to $7.60 -- a 42% discount.

In effect, we’ve reduced the cost of insurance to $6,080 or 2.9% of the total value of the portfolio.

The limited protection effectively covers another potential selloff in the NDX 100 ETF (QQQ) down to 230 (an 11% decline).  That level also happens to be below the 50-day moving average (blue line in the image above) and in the vicinity of technical support.

If you own a basket of securities, portfolio hedging using options can be an effective means for managing your risk.

If you want to guard against a potential “tech wreck” over the next few months, look to spend a small portion of your gains by purchasing Put spreads in the QQQ.

Your portfolio may thank you for it.

Until next time!

Costas

Costas

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