By: Costas Bocelli — December 31, 2020
Will the Bull Market Die in Five Days?
It’s New Year’s Eve… and the last trading day of the year!
When we reflect on 2020, it will be remembered for two contrasting things:
A global pandemic that infected 83 million people and claimed 1.8 million lives around the world.
And a global stock market at an all-time high.
Have a look at the iShares MSCI World ETF (URTH), an exchange traded fund that has exposure to a broad range of developed market companies around the world.
(Click any image to enlarge)
World stocks are leaving 2020 at record highs.
The German DAX is at an all-time high…
Japan’s Nikkei 225 sits at a 30-year high…
And all of the major U.S. indices are at record highs, led by the technology-heavy NASDAQ Composite.
Should the COMP rise another 0.02% in today’s session, it will collect its 56th all-time record closing high of the year. The “NAZ” leads all indices with a 43% gain year-to-date!
So clearly the bulls are in strong control as we ring in 2021.
And it’s a very similar circumstance as was at the start of this year
Stocks were hitting new highs, sentiment was very bullish and breadth indicators were towards overbought.
What brought it all to an abrupt end came out of seemingly nowhere, a black swan event, so to speak.
Originally dubbed the Wuhan Flu, a novel virus, quickly spread from a region of China and made its way around the world wreaking havoc on humanity and economic activity.
By March, the world was in recession and the stock market in a bear market.
The bull was laid to rest. Another victim of the coronavirus.
But like a Phoenix rising from the ashes, a new and stronger bull market emerged, one that has pushed the major indices above those prior highs.
Now, there stands little in the way of resistance as we move into a new year.
So what’s the next hurdle for this bull market?
More sickness… a war… a geological event, or another black swan no one sees coming?
Of course, someone can only speculate.
But for us, we focus on the "true market".
We let price be our guide, no matter what the circumstance may be.
And what we do know is how the stock market reacted since the November Elections.
The stock market likes certainty.
It also likes the prospect of a divided government.
It’s all but certain that Joe Biden will be sworn in as the next president of the United States.
The House of Representatives will also remain in the hands of the Democrats.
But the Senate is anticipated to be controlled by a razor-thin Republican majority.
That is a significant development as many of Biden’s policy objectives, including a reversal of Trump’s corporate tax cuts, would be stymied.
Now here’s the thing…
The Senate make-up is 52-48, with the edge to the Republicans.
But two of the Republican Senators, both from Georgia, are in a run-off for their seats.
Republican Sen. Kelly Loeffler, who was appointed to her seat after Senator Johnny Isakson retired, is facing off against Democratic challenger Raphael Warnock in a special election.
And incumbent Republican Sen. David Perdue is running for re-election against Democratic challenger Jon Ossoff.
The Georgia Senate Election Day is soon approaching, on Tuesday, January 5th.
That’s five days from today!
For the Senate to flip “blue” and the Dem's regain control they’ll need to win both of the seats.
Winning one seat won’t cut it.
The latest polls are extremely tight, but the odds-makers favor the Republicans.
And likely, so does the stock market.
But what if Mr. Market sees it wrong and the Democrats win both seats?
That would mean the Democrats would have control of the White House, the House and the Senate.
And an outcome that would not only cause a paradigm shift, but a potential repricing of risk assets.
The CBOE Volatility Index (VIX), aka, "the fear gauge", remains elevated heading into the special election.
Some market strategists see a major selloff should the Senate flip.
So for those investors that want to maintain bullish exposure but are concerned about downside risks could look to construct an easy-to-apply hedging strategy.
You can easily grab downside protection using an exchange traded fund.
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 U.S. centric stocks.
And let’s say the current value of the portfolio is $200,000.
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 broad market selloff, we can look to an ETF that tracks one of the major US stock indices.
In this example, we’ll use the iShares Russell 2000 ETF (IWM), a major index comprised of small-cap stocks. This group has gone up the most since the November election and is excessively overbought in the short-term. So should the market get derailed, this one has plenty of room to fall.
Step #2 is to identify the price of the ETF.
On yesterday’s close, the IWM was $196.40 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.
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 $19,640.
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 $200,000 we’ll divide it by $19,640 which equals 10.18
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 10 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 10 IWM March 195 Puts. With IWM recently $196.40 per share, each Put option would cost $9.50, or $950 per contract.
That means you’d need to spend $9,500 (or about 5.0% of the portfolio value) to create a hedge that will protect a $200,000 portfolio and offers unlimited downside protection over the next 78 days. (The Put option contract expires March 19th, 2021).
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 23 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 IWM March 175 Put options for $4.00 each (or $400 per contract) and reduce the overall cost of the hedge from $9.50 to $5.50 -- a 42% discount.
In effect, we’ve reduced the cost of insurance to $5,500 or 2.8% of the total value of the portfolio.
The limited protection effectively covers a potential selloff in the Russell 2000 index (IWM) down to $175 per share (a 10% 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.
Hedging through the IWM is one way to go about it.
Wishing you and your family a Happy, Healthy and Prosperous New Year!