The Cheapest Insurance For Your Portfolio

Includes: SPY, UUP
by: Danny Furman

I recently watched a particularly thought-evoking episode of financial media. On November 21 Lauren Lyster, host of Russia Today's Capital Account, interviewed Artemis Capital Management's Vega Fund Manager Chris Cole. The episode can be seen here in its entirety.

Mr. Cole discusses volatility and explains that investors are currently highly concerned about it. So much so, in fact, that hedging a portfolio for 8 months into the future is more expensive now than it was immediately following the collapse of Lehman Brothers in September 2008. He goes on to advocate buying short dated volatility and selling long dated volatility.

My initial reaction to the show was to pat myself on the back, as throughout 2012 I've been successfully, though far from flawlessly, doing half of what Mr. Cole suggested: Buying short dated puts when the market appears overbought.

While I don't plan on abandoning the strategy of buying short dated puts on volatile equities such as (NASDAQ:AMZN) and calls on the leveraged short smallcap ETF (NYSEARCA:TZA) when the timing appears to be right, a longer dated trade favoring significant weakness in equities markets- albeit with a less volatile trading vehicle- is at the top of my holiday wishlist.

Looking at put options with a June 2013 expiration, to make a 100% return (not overly ambitious with a "naked" option trade) with the S&P 500 ETF (NYSEARCA:SPY) we would need the index to trade near 1300 from a current level of 1415, or diminish by 10%. This assumes the December 4 2012 price for $135 puts of $5.50. To make 300% we would need the S&P to approach 1200. July 2013 $250 puts on AMZN currently cost over $24, meaning the stock would need to trade near $200 to make 100% and $150 to make 300%. As Chris Cole suggested traditional long dated hedging instruments do not offer attractive risk reward.

More volatile stocks and ETFs garner even higher time premiums, so we are ideally searching for a trading vehicle with a very low beta that offers options. Without a doubt the gleaming choice is UUP.

The Powershares US Dollar Bullish Index (NYSEARCA:UUP) tracks the performance of the USD against a basket of international currencies. The index moves with a near perfect negative correlation to global stock indexes. Over the last two years it has remained in a tight range between $21 and $23, and currently sits at $21.79. The index does move substantially during times of panic, however, spiking from $22.30 to $27 over a three month period in mid 2008 and rallying from $22.26 to $25.77 from late November 2009 to late May 2010. Such is to be expected, as the USD is the world reserve currency and benefits from "flights to safety."

Since UUP has a negative correlation to equity markets, investors should look at calls for insurance for long portfolios. June 2013 $23 calls strike me as the most appealing, currently trading at .12. If the market stays near flat or rises without a big shock over the following seven months the options will expire worthless. If, however, markets see the kind of deflationary demolition the likes of Robert Prechter, as he discusses here in a recent debate with hyperinflationist Peter Schiff, are calling for over the horizon and UUP rallies $2 to $24, the calls will be worth over $1 each, representing a nearly 1000% gain. UUP reaching $26 would yield over a 2500% gain.

Investors seeking a lower risk, lower reward trade should consider the June 2013 $21 calls, currently trading at .85.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in UUP over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.