Two Safe Havens

I got two smart responses to my assertion that there’s no safe haven for investors these days. Jared Woodard at Condor Options responded with 1,500 words on how investors in an S&P index fund can buy put options to protect their downside: “any hedging at all is better than none,” he writes. Meanwhile, maynardGkeynes left a much shorter comment:

TIPS are both easy and obvious.

Of the two, I prefer the TIPS. Why gamble in the stock market at all, if you don’t need to? Jared’s options strategy is akin to buying insurance that your bet won’t pay off, without stopping to wonder why you’re making the bet in the first place. The main advantage to the options strategy is that if things really blow up, and there’s a major stock-market crash on the order of 60% or so, you could actually end up making a profit. But I think an investor who was invested in TIPS during such a chaotic time would be perfectly happy with her choice.

There are two small problems with the TIPS strategy. One is that the tax implications of investing in TIPS can be extremely complicated, and taxpayers might want to consider the cost in accountancy fees before going down that road. The second is that it doesn’t scale: the whole point of financial markets is that they turn savings into investments, and we actually want people with savings to be willing to take a little bit of downside risk.

In that sense, Jared’s strategy of buying long-dated puts and selling them six months before expiry is better. It brings with it most of the upside associated with stock-market investments, it helps move money into equities (which, over the long term, is something society prefers to having it create bubbles in the debt market), and it helps the investor sleep at night with regards to black-swan events. What’s more, it involves a little bit of work: that’s a good thing, since investing shouldn’t be brainlessly easy. On the other hand, it also involves a significant transfer of funds from the Main Street investor to Wall Street, which always makes money on options trading.

Still, both strategies are worth considering for people with investments. In general, I’d recommend the TIPS approach to people who are likely to be able to make money the best way, by earning it: in that case TIPS are a safe place to put your hard-earned cash. (Especially if you are very unlikely to move abroad, and aren’t worried about a falling dollar except insofar as it feeds through into inflation.) On the other hand, people who are looking to earn money through capital rather than labor will probably not be happy with the modest return on TIPS and might be happier with Jared’s approach.

Comments

[Bernie2:]

I posted this on Jared's website in response to his article (linked above) where he proposes a simple strategy of buying a $80 Dec 2010 put for SPY as a hedge. I thought maybe some readers here might have some advice on my comments, too:

"I perfectly fit your target audience. Not very experienced in investing … and found your article very helpful. Thank you! I am going to adopt this or a similar strategy and I think it will make me sleep better! :-)

One question: Wouldn’t it be much cheaper to buy monthly puts and keep buying new ones every month? When I looked up the option quotes I saw that I could get a $80 put for SPY for mid December for about 5c. That would be 12×5c= 60c per share per year – ok 70c with commissions and fees – for 12 monthly contracts compared to almost 4 $ for a December 2010 put.

I can see that if the stock market were to slowly go down over the year the $80 puts would get more expensive. I don’t know how the put prices were in the months before the recent market crashes in 2008 and 2009, but weren’t these crashes quite unexpected? Were the monthly puts getting significantly more expensive before these events?

I can see two scenarios: an unexpected market crash in which case this strategy seems cheaper or a prolonged downward trend in which case the puts would get more and more expensive but then couldn’t I not switch to going short on spy or buying a short spy etf instead of buying puts.

I know you wanted to present something really simple for people like me but I am willing to learn a little more and put in some work myself. Any advice would be appreciated.

Thanks

Bernard"

Nov 14 07:02 AM

[nym:]

Everything has a good price - there just may not be a willing seller. Is the supply of TIPS unlimited if the herd follows Felix's advice?

Nov 14 01:20 PM

[American in...:]

The adjustment in principal value of a TIP bondmade by the government is taxable. Not very attractive.

If you buy puts, buy long because the short term puts decay rapidly and you incur a lot of transactions costs rolling the short term puts over.

Nov 15 05:21 PM