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By: Costas Bocelli — April 22, 2021

Might Be Time To Add Insurance to Your Portfolio

After a year of pure hell on so many fronts, I can't believe I'm about to say this only 112 days into 2021, but here goes: It's hard not to be optimistic about the rest of the year and beyond.

I mean, numbers don't lie:

    • Half of U.S. adults have received at least one vaccination.
    • Retail sales skyrocketed nearly 10% in March, the largest in 10 months.
    • Manufacturing data shows the sector at its highest growth level since August 18.
    • The Gross National Product (GNP) is expected to hit 8% in the first quarter when official figures come out. That rate would return the U.S. to pre-pandemic levels, and do so a couple of quarters earlier than anyone thought.

Then, just when you think things couldn't possibly get any better, along comes earnings season, blowing analysts' first-quarter estimates out of the water thus far.

Companies in the S&P 500 that have already reported have beaten expectations by a combined 30%, according to FactSet. That's up from an average 7% five years ago. If that trend continues, it'll be the highest number ever recorded.

The positive impact of all this good news on the stock market isn't surprising.  All that good news is fueling a fire sparked in April last year following a nasty but short pandemic-induced bear market. As a result, we've seen the Dow Jones Industrials, and S&P 500 reach higher and higher highs.

And, that makes me nervous. As an investor, it should make you nervous too. It's OK to be optimistic,  but -- above all -- we need to be realistic and prepared.

Like I said, numbers don't lie -- and neither do technical indicators.

They didn't lie last March when they said the market was deeply oversold. And they're not lying to us right now, when they say the market is very overbought.

Here's a recent snapshot of the S&P 500 %30 Week MA indicator I pulled from the Sector Prophets Pro platform. It shows that 96.02% of stocks in the large-cap index are trading above their respective 30-week (150-day) moving averages.

That’s more than excessive -- it's almost "off the charts."

(Click any image to enlarge)

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Could it be the case that, with so much big money participating in the current bull market, my reasons for optimism -- economic recovery, progress against the pandemic, and stellar earnings -- are already "baked into the cake?"

Have investors entered "what-have-you-done-for-me-lately" mode?

Could be...

Consider the sheer rate of growth. According to CFRA Research, the 90% rise in the S&P 500 (see chart below) since the collapse last March is the biggest first-year, post-bear gain since 1945.

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Include the Dow Jones Industrial Average (up almost 88%) and the Nasdaq Composite (up 100%+) and collectively they outpace the average of 37.5% for all prior bull markets.

Granted, we've seen declines along the way. In February and March, after leading the market for so long, the Technology sector corrected 15%. Then energy stocks, after a huge bounce off their COVID bottoms, fell 13% over two weeks.

But, historically, it's not rare to see multiple corrections or short-term pullbacks during a calendar year.  That doesn't mean you should sell all the assets in your portfolio. It does mean that hedging strategies to reduce risk -- and a different growth component in your portfolio -- can't hurt.

Like they say, just because your house ain't burning doesn't mean you don't need insurance.

So investors who want to maintain upside exposure but are concerned about downside risk can look to construct an easy-to-apply hedging strategy.

You can easily grab downside protection using an exchange traded fund (ETF).

How to Create a Portfolio Hedge Using ETFs (In Five Easy Steps)

Let’s say you own a portfolio of U.S.-centric stocks.

And let’s say the current value of your portfolio is $200,000.

Step #1 is to select which ETF you will use to create your hedge.

Since we are guarding against a broad market selloff, we can look to an ETF that tracks one of the major U.S. stock indices.

In this example, we’ll use the SPDR S&P 500 ETF (SPY), a major index comprised of widely-held large-cap stocks.  The S&P 500 has largely been immune to the "rolling correction" we've seen since February when interest rates spiked.  So should the market happen to turn really messy, this ETF has plenty of room to fall.

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

When I was looking at SPY yesterday morning, it was trading around $413 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 of the ETF.

In our example, the notional value is $41,300.

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 $41,300 which equals 4.84

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 in this example is five Put option contracts.

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 that has about 90 days until it expires. That's the "sweet spot."

In this example, you could look to buy five SPY July 400 Puts. With SPY recently $413 per share, each Put option would cost $9.60, or $960 per contract.

That means you’d need to spend $4,800 (or about 2.5% of the portfolio value) to create a hedge that will protect a $200,000 portfolio and offers unlimited downside protection over the next 85 days. (The Put option contract expires July 16th, 2021.)

Typically, you should look to spend no more than 3% to hedge the portfolio so this structure looks reasonable in today's environment.

Market volatility is relatively low right now compared to where it's been post-Pandemic -- the VIX is now under 20 (around 18), which is still historically above the longer-term average, but at the lowest level since February 2020.

In other words, hedging against downside risk is about the cheapest its been since COVID.

But as the GEICO Gecko says, "why pay more when you can get it for less?"

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’ll find it can still provide substantial protection for a fraction of the cost.

In our example, you could look to sell the SPY July 360 Put options for $3.70 each (or $370 per contract) and reduce the overall cost of the hedge from $9.60 to $5.90 -- a 39% discount.

In effect, we’ve reduced the cost of insurance to $2,950 or 1.5% of the total value of the portfolio.

The limited protection effectively covers a potential selloff in the S&P 500 index ETF (SPY) down to $360 per share (a 10% decline).  That level also happens to be at a key level of support and in the vicinity of the 200-day moving average (blue line in the above SPY chart).

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

Hedging through the SPY is one way to go about it.

Cautiously Optimistic,

Costas Bocelli

 

 

 

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