Protect Your Portfolio Against Volatility

Jan. 7.13 | About: SPDR S&P (SPY)

Previously, I had written an article about using the VIX as an indicator, rather than a trading vehicle. The VIX, or CBOE SPX Volatility Index, which measures the volatility of the S&P 500, has been crushed over the last week. On Monday, the VIX opened at $21.05. On Friday, the VIX closed at $13.83 a drop of more than 33% over the last four trading sessions (Tuesday the markets were closed). So where does this leave investors? Lets take a look at the S&P 500 ETF (NYSEARCA:SPY) when the VIX performs like this.

As I first mentioned, I don't trade volatility products such as the double-levered ETF (NYSEARCA:UVXY) or double-levered ETN (NASDAQ:TVIX). I have just seen so many traders and investors use them and lose their shirt, plus a little more. There are exceptions, but in general I try to avoid them. Instead, I just use the VIX as an indicator to what might happen in the markets. Historically, when the VIX closes below $14, it doesn't take very long for it to rally back into the upper teens. Below is a three-year chart illustrating this fact:

Click to enlarge images.

Click to enlarge


Typically, when the VIX is below $14, it is seen as a top in the SPY. And when the VIX is high, it indicates that markets are behaving violently and are usually selling off rather aggressively. Below is a one-year chart of both the VIX (in blue) and the SPY (in orange) and what the price action has been like over that time span:

Click to enlarge


So what does this mean exactly? In my opinion, equities will likely begin to sell off in the coming days and potentially weeks. Some will sell short the market, while others might take gains in their long positions. I would recommend hedging long-term portfolios against a potential market pullback by either purchasing put options on individual stocks or on the broader market in general. This can be done by purchasing at-the-money or slightly out-of-the-money SPY put options. Below is an example:

Buy 1 January SPY 146 put @ 1.16

Net Debit (Max Loss): 1.16 ($116)

Days Until Expiration: 14

Delta: -48

If you think that is too much exposure, then you could consider creating a bear put spread, which involves purchasing a put (such as the January 146) and selling a lower strike put for a small credit. Overall, this trade will still be put on for a net debit, but will have less risk in terms of direct premium. Below is what the trade would look like with the short leg added in:

Buy 1 January SPY 146 put @ 1.16

Selll 1 January SPY 142 put @ .23

Net Debit (Max Loss): .93 or $93

While there are only 14 days remaining until expiration, this is something that usually happens rather quickly. Creating the put spread might be a more effective way to play the move if you're looking for lower premium. While this trade is quick in nature, it plays a healthy role in properly identifying when there may be appropriate times to hedge a long-based portfolio.

But how do long-term investors use something like this to their benefit? After all, they are long-term investors, not traders. Instead of entering the risky world of trading volatility, simply use it as an indicator. Over the past several years -- as noted on the three-year chart above -- when the VIX closes below $14, the SPY almost always goes on to sell off over the next few days or weeks. If a long-term investors knows this in advance, the purchasing of SPY puts or puts on individual positions will help keep their portfolios strong.

The argument could be made, "If we're long-term investors, why does it matter anyway?" Well, let's say the SPY corrects an average of 1% each time the VIX closes below $14, and this happens three times per year. I'm just eye-balling it here, but that's over 30% in a decade (3 x 1% x 10 = 30%). Now, wouldn't you want to save that 30%? I know I would.

By knowing when and how to properly hedge their portfolio, investors can save a ton of money over the long haul. While the move may be short-term in nature, when protected against, the long-term investor is as much a winner as the trader is -- perhaps even more. It results in more money and a stronger portfolio, plus the knowledge of beneficial timing when looking to protect the money we've worked so hard to make.

Knowing when to buy, sell, and hedge is just as important as knowing what to buy, sell and hedge. While a long-term portfolio may do extremely well over a 20-year span, there's no question it will do much better when the manager knows how and when to protect it. Right now is a good time to start protecting.

While the VIX may continue to trickle lower, as investors have seemingly put their guards down, it's better to be safe rather than sorry. The markets may begin to take some of those early year profits off the table, as stocks could be seen as slightly extended. Either way, for the small price of insurance, it's both smart and cost effective to protect the long-term holdings in our accounts.

Disclosure: I am short SPY. 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.