Hedging Against Market Risk by Buying Puts on ETFs That Track Indexes

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 |  Includes: DIA, IWM, QQQ, SPY
by: David Pinsen

As we noted in a Seeking Alpha article last month, the kind of risk management that seems to be mentioned most frequently in popular investment columns is diversification. Diversification has a significant limitation though.

Diversification reduces idiosyncratic risk

Diversifying among a basket of different stocks reduces idiosyncratic (or, stock-specific) risk, but not market risk. An example of idiosyncratic risk would be if news broke that the CFO of a company you owned stock in had been cooking the books. In that case, you’d obviously be better off if you’d had your money diversified among five or ten different stocks instead of having all of your money in that one, shady stock. When the market tanks though, nearly all stocks get hammered. That’s market risk.

Diversification doesn't reduce market risk

In fact, not only does diversifying among a basket of different stocks not protect you from market risk, but diversifying among different, putatively non-correlating asset classes (e.g., stocks, bonds, commodities) doesn’t always help you either. The problem there is that when the worst happens, correlations go to one: almost everything tanks. For example, when the stock market crashed in 2008, so did commodities, corporate bonds, and other asset classes (about the only asset that did well was U.S.Treasuries, but that doesn’t mean that they’ll do well next time the market tanks).

Hedging against market risk

So how can an investor protect himself against market risk? One way is by hedging. And one way to do that is by buying puts on ETFs that track market indexes. Here are a few examples of market indexes and the ETFs that track them:

  • The Dow Jones Industrial Average: SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA)
  • The S&P 500: SPDR S&P 500 ETF (NYSEARCA:SPY)
  • The Nasdaq 100: PowerShares ETF (NASDAQ:QQQ)
  • The Russell 2000: The iShares Russell 2000 Index ETF (NYSEARCA:IWM)

You can find a list of put options available on those index ETFs by clicking on the "options" tab on their quote pages on sites such as Yahoo! Finance, Morningstar, or Google Finance. For example, here is a list of options available for IWM, the ETF that tracks the Russell 2000 small cap index (scroll down on that page for the put options). As you can see from clicking that last link, there’s a whole lot of them. Which one should you buy if you want to hedge?

Choosing a decline threshold

First, you have to ask yourself how much of a market decline you’re willing to tolerate (all things equal, the bigger the decline you’re willing to stomach, the cheaper it will be to hedge against — similar to how car insurance will be cheaper when you have a higher deductible). The threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.

Finding optimal puts

Once you know how much risk you’re willing to risk (whether it’s a 20% decline or some other threshold), you’ll want to find the optimal puts — the ones that will give you the level of protection you want at the lowest possible cost.

With Portfolio Armor (available in Seeking Alpha's Investing Tools Store, and as an iOS app), you just enter the symbol of the stock or ETF you’re looking to hedge, the number of shares you own, and the maximum decline you’re willing to accept (your threshold), and then the app uses its proprietary algorithm to scan for the optimal puts.

A note on costs

To be conservative, Portfolio Armor uses the ask prices of the optimal options to calculate the cost of protection. In practice, an investor will sometimes be able to buy the options at a slightly lower price, one between the bid and ask prices.

Times to expiration

In his research, the finance academic who developed Portfolio Armor's algorithm found that options with approximately six months to expiration (which today would be the ones expiring in November) tend to offer the best combination of liquidity and cost, so those are the put options for which Portfolio Armor's algorithm aims. When puts with about six months to expiration are not available, Portfolio Armor searches for slightly longer or shorter times to expiration.

The table below lists the costs, as of Monday's close, of hedging against greater-than-20% declines in four index-tracking ETFs over the next several months, using the optimal puts for that.

A difference between this month and last

Readers of last month's article may notice that the cost of hedging against a >20% decline in DIA looks considerably higher this time -- 1.49%, versus 0.89% last month. One reason for that difference is that the optimal puts on DIA mentioned in last month's article had five months until expiration, and the optimal puts on DIA listed below have seven months until expiration. All things equal, options with expirations further out generally cost more.

Symbol

Name Cost of Protection (as % of position)

(QQQ)

PowerShares QQQ Trust

2.11%**

(SPY)

SPDR S&P 500

1.77%**

(DIA) SPDR Dow Jones Industrial Average 1.49%**
(IWM) iShares Russell 2000 2.74%*
Click to enlarge

*Based on optimal puts expiring in November, 2011.

**Based on optimal puts expiring in December, 2011.

Disclosure: I am long a few puts on DIA