In the interest of full disclosure, it is this author's opinion that the market will continue to be able to sustain its recent rally. In earnest, I see the market returning 10%-14% again this year based on healthy underlying corporate fundamentals and the amount of investor cash that still remains parked on the sidelines (more on that detailed in the article here). In fact, the current investor uncertainty alone surrounding the direction of potential movement of the market reaffirms my opinion that the bull market can continue. It isn't until all investors are "certain" that the market will continue to generate 10% returns year over year (read: just prior to tech bubble and real estate/credit bubble) that I would become anxious and begin to shift away from equities. However, the fact remains, our clients continue to come to us requesting ways they could benefit/hedge their positions if the market does incur a post-market rally, pullback. And given the current fixed income yield environment, coupled with the fear of a "Great Rotation," bonds exclusively no longer offer the same type of hedge protection they once did against equity market declines. So where can investors stash some cash to hedge their bets and protect themselves from a "red" market while still being able to capitalize if the market lands in the "black?"
As stated earlier, record high prices and low yields (which move inversely to prices) have resulted in a fixed income market that no longer offers the protection against a decline in the equity markets that it once did. In fact, any number of investment talk shows and/or publications have dubbed this year the year of the "Great Rotation" -- a mass exodus of cash from fixed income investments into the equity markets. Such an event would act to depress fixed income prices as issuers would have to begin offering higher yields to entice investment in their corporate debt. Moreover, the above average unemployment rate has allowed the Fed to continue its purchasing of fixed income securities while inflation has remained in check. However, as the economy continues to recover and the unemployment rate decreases, one would expect that inflation will begin to creep up. When this happens, we expect that the Fed, in keeping with its duel mandate of full employment and low inflation, will gradually exit its purchasing position of Treasury securities. This action would act to decrease the demand of government debt which will begin to push the yields of such debt higher (and prices will fall). That said, while fixed income doesn't offer the protection that it once did against a decline in equity prices, investors tend to exhibit a "flight to safety" response in the event of steep declines in the markets, seeking the havens of government debt. Accordingly, very short-duration (emphasis added), government-sponsored paper should act as a shock absorber against a significant pullback in the market while limiting the investor's exposure to an increase in market interest rates. Potential options include funds such as: iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY), Vanguard Short-Term Government Bond ETF (NASDAQ:VGSH), and SPDR Barclays 1-3 Month T-Bill (BIL), among others.
The Chicago Board of Options Exchange Market Volatility Index ("VIX") uses options on the S&P 500 ("S&P") to track the expected short-term volatility in the market. Commonly referred to as the "Fear Index," the VIX tends to perform its best when the market's return expectation is at its worst. The negative correlation acts to provide an excellent hedge against market sell-offs. The chart below details the performance of the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ) against the S&P. As can be observed from the chart, the VIX ETN exhibited some of its largest upward moves, as the S&P fell. Over the entire historical period detailed in the chart, VXZ lost approximately 75% while the S&P gained 75%. It should be noted that using the VIX to hedge your investment is recommended as a short-term play only. Given the expectation of a positive market return over the long-term, which empirical studies tend to support, an exclusive position invested in the VIX index would be expected to guarantee a losing position in the portfolio.
Market Put Option Contracts
Purchasing a put option on a security that you already own (commonly referred to as a "protective put" position) is essentially like buying insurance on an owned asset. The put option protects your downside risk because the seller of the contract agrees to pay the buyer an agreed upon price ("strike price") at a date certain in the future. If the market price falls below the strike price, the buyer of the option is made whole on the contract by receiving the difference between the market value at expiration and the strike price. However, if the market price is above the strike price at expiration, the option simply expires worthless, the seller of the option retains the premium, and the buyer only loses the premium paid. Just as with insurance, as the risk that is willing to be borne by the owner of the asset increases (this is accomplished with the option by decreasing the strike price, which is similar in concept to an individual increasing her insurance deductible), the required premium decreases. As an example, assuming the S&P is at the 1,500 level, if an investor that is long the market would only be willing to incur a 100 point decline (-6.67%) a put option with a March expiration date could be purchased at the 1,400 level at a premium of $3.83 per contract (contracts are typically based on 100 shares of the underlying security meaning that the total premium would cost the buyer $383.00). However, if the investor were willing to incur a potential maximum 200 point loss (-13.33%), the required premium would be $1.05 ($105 total cost). By purchasing such a contract, the investor has effectively locked in the potential loss their position could incur, while still retaining all of the upside potential if the market moves higher.
In summary, while it is this author's opinion that the market rally will continue to sustain itself, there exist a number of ways for those maintaining a less optimistic outlook to limit their potential downside risk while still being able to participate in a bull market run. If played correctly, these strategies offer better odds than the house because regardless of whether the market lands on red or black, an investor can still earn green.
1 As of 6/30/2012, the correlation of VXZ with the S&P was -0.79.
2 Data courtesy of Morningstar.
3 Priced as of 2/18/2013 for March, 2013 expiration.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.