Have you paid your portfolio insurance premiums this month?
"Say what!?" you say.
Well, you likely pay health insurance premiums… and for home owner's insurance… and for car insurance. Yet many investors forget to insure their investment portfolio which, for many, is their largest asset. I've never understood this.
I don't know how to make odds on this, but I think we have a better chance of seeing a 5% to 10% correction in the equity markets than we do of losing our houses to a fire or flood. Regardless… between the financial turmoil in Europe, Japan's $1 billion injection overnight, and a thoughtless leader in North Korea, I think a sharp correction could be in the cards.
If you have a stock portfolio -- I have some ideas on how you can "insure" it. The chart below shows S&P 500 futures. I'm watching Fibonacci levels (white dotted lines) for potential correction targets.
So let's talk about the nuts and bolts of this hedge…
First, consider how closely your current stock portfolio tracks the S&P 500. If you're overweight certain sectors, or if you consider yourself a stock picker, you may want to hedge more or less accordingly. I use the S&P 500 as an example as it serves as the benchmark for most funds and portfolio managers. If your portfolio is heavily concentrated in small-caps, you might consider hedging with Russell 2000 futures instead. But I digress…
The margin for one (1) ES futures contract (e-mini S&P 500) is roughly $4,000. This lets you control roughly $77,650 of equities exposure (at $50 per point, current price x $50 = $77,650). Now, let's say you want to spend between 3% and 7% of your portfolio's value to protect the remaining 93-97%. You could have a near perfect hedge by shorting about 13 futures contracts, requiring roughly $52,000 in margin.
Again, this is not meant to be a speculative trade… only an "insurance policy" on your long equity portfolio. And just as most people don't hope and pray for a house fire… just so they can get paid on their insurance policy -- we are not necessary wanting to see the hedge pay out. Shift your mentality accordingly.
The idea is to offset losses in your equity portfolio with gains on the short futures positions. What if I'm wrong and the S&P 500 keeps ratcheting higher? Well, we just consider our "insurance premiums" paid and move on. If this happens, it likely means you're making money in your stock portfolio. That's your main goal -- the hedge just helps you sleep better at night. And hey -- you don't gripe with Geico every month that you don't get into a car accident, do you?
Risk Disclaimer: The opinions contained herein are for general information only and not tailored to any specific investor's needs or investment goals. Any opinions expressed in this article are as of the date indicated. Trading futures, options, and Forex involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.