There's no denying it. Depending on which talking head you are listening to, the market is either fully valued or in mild bubble territory. The stock market, as measured by the ETF SPY reached an all-time high today. So what's a reasonable investor to do to protect a portfolio from a possible market correction? I suggest using options to hedge risk and to move away from a linear risk/reward profile. When you own stocks, your profit or loss depends on the change in the stock price and the payoff is perfectly linear.
How Options Help
Options give you the ability to change the shape of the payoff profile, which can result in lots of fun shapes in complex option strategies. For this article we will only concern ourselves with the most basic option strategy, which has a payoff that looks like a hockey stick. Here's a simple chart to show how adding a long put to your long stock position changes the shape of the payoff diagram.
The simplest way to hedge your long stock while still staying invested is to buy put options. Option prices are currently super cheap, with the VIX hovering just below 12. The VIX doesn't get this low very often. Buying put options is conceptually similar to buying insurance. You pay a small amount upfront to buy protection from a bad outcome. If a bad outcome does happen, you will be glad you bought the insurance. On the other hand, if a bad outcome does not happen (if stocks rise or go sideways), you wound up buying insurance you did not really need. But you will still sleep soundly, because you know you are protected. As with car insurance, or homeowners insurance, it's usually hard to tell if you need it beforehand. However, unlike other types of insurance, the cost of protection for your stock portfolio varies over time significantly. The below chart shows the VIX index, which represents cost of buying insurance on the S&P 500 index. A lower VIX means option prices are low. Right now we are at the lowest level in more than a year.
The traditional thinking is that the market is telling us that it is not worried about a correction. On the other hand, this could also be a sign of too much complacency on Wall St. Since the VIX tends to be backward looking, I'd take the view that low option prices won't necessarily translate into stable stock prices going forward. Instead, it simply means that we haven't had any large moves over the last few weeks, and this has depressed option prices. Any way you want to look at it, I think option prices are cheap, and buying some protection right now seems prudent to me given the level of stock prices.
BTW, you don't have to use put options. If you don't feel up to trading options, there are still several ways to trade volatility using ETFs. Buying VXX, VIXY, TVIX, or UVXY provides a hedge similar to what could be accomplished by buying put options. You will get a big payoff if stocks fall. Inverse ETFs provide access to a similar strategy that you can employ by selling XIV or SVXY. You could also buy VIX futures directly if you have deep pockets.
Disclosure: I am short VXX and long 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.