Hedging against a 50% Market Drop
In an article earlier this week on TheStreet.com ("Hedge Against Market Risk With Default Servicers"), Glen Bradford considered the possibility of a 50% market decline:
Let's settle for just hedging against market risk. Market risk is the risk that the value of a portfolio, either an investment portfolio or a portfolio, will decrease due to the change in value of the market-risk factors.
So let's assume that the stock market goes down 50%. Granted, this is unlikely to happen with the seemingly inevitable monetization of the deficit. But if the market tanks, housing will fall.
Bradford's indirect hedge
Bradford went on to suggest "taking a look at default, foreclosure, short-sale servicing companies to hedge against the market risk", and he mentioned three specific names: The Dolan Company (DM), Altrisource Portfolio Solutions SA (NASDAQ:ASPS), Lender Processing Services, Inc. (NYSE:LPS).
A problem with Bradford's hedge idea
Bradford's logic here is that if the market tanks, housing will fall, and if housing falls, those three companies will benefit. That may be true, but it's also true that in a severe correction, correlations tend to converge toward one. So it's likely that if the market tanked by 50%, those default, foreclosure, and short-sale servicing companies would tank too.
Betting on those stocks to rise when the market crashes sounds like an example of the "defensive portfolio hype" that Seeking Alpha contributor Sy Harding warned about a few months ago:
The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But the advice remains the same in every cycle.
After the market seemed to top out in the year 2000, the stocks most recommended as defensive stocks included Alcoa (NYSE:AA), Bristol Myer Squibb, Citigroup (NYSE:C), Coca-Cola, Disney (NYSE:DIS), DuPont (NYSE:DD), Fannie Mae, General Electric (NYSE:GE), Home Depot (NYSE:HD), IBM (NYSE:IBM), Merck (NYSE:MRK), and WalMart (NYSE:WMT). However, they plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the Dow’s decline of 38% and the S&P 500 decline of 49%.
Another problem with Bradford's hedge idea
Even if you somehow knew that shares of those three default, foreclosure, short-sale servicing companies would appreciate when the market crashed, how would you know how many shares of them to buy to give you a sufficient hedge?
A better way to hedge
As we mentioned in a post in May ("Optimal Puts versus Inverse ETFs for Hedging"), precision is one of the advantages of using optimal puts to hedge:
Precision. Say you own 821 shares of Kraft Foods, Inc. (KFT), and you'd like to know how to hedge that position against a greater-than-18% loss. Using Portfolio Armor (which is available in the Seeking Alpha Investing Tools Store and also as an Apple iOS app), you could simply enter "KFT" in the symbol field, "821" in the number of shares field, and "18%" in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost. (1)
Step 1: Enter a ticker symbol
If you want to hedge against market risk, a good proxy would be an optionable ETF that tracks a market index. A few examples are the iShares Russell 2000 Index ETF (NYSEARCA:IWM), the PowerShares QQQ Trust ETF (NASDAQ:QQQ), and the SPDR S&P 500 ETF (NYSEARCA:SPY). We'll use SPY for the purposes of this example, which is why "SPY" is entered in the Ticker Symbol field in the screen cap below.
Step 2: Enter a number of shares
Since you're using SPY as a proxy here, you'll want to enter a number of shares that corresponds with the dollar amount of the portfolio you want to hedge. For the sake of simplicity, let's assume that portfolio is worth $100,000. In that case, the number of shares we'd enter would be $100,000 / the current share price of SPY ($130.22, as of Thursday's close) = 768, which is the number we've entered in the "Shares Owned" field below.
Step 3: Enter a decline threshold
50% seems like a pretty steep decline to expect: for example, in the event of a U.S. default, Credit Suisse estimates stocks would fall by 30%. In previous posts, I've mentioned why I usually use 20% as a decline threshold, but since Glen Bradford raised the prospect of a 50% market decline, we'll go with that in this example. We've entered 49% in the "Threshold" field in the screen cap below because that's the lowest we're willing to see our position drop in this case -- we want to be hedged against a 50% drop.
Step 4: Click the red button
A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge against a >49% drop in SPY between now and January 21st, 2012. The cost of this protection on a $100,000 position would be $175, or 0.175% of the position value.(2)
Note that, as in the case of the KFT example above, Portfolio Armor rounded down the number of shares of SPY we entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then presented us with 7 of the put option contracts that would slightly over-hedge the 700 shares of SPY they cover, so that the total value of your 768 shares of SPY would be protected against a greater-than-49% decline.
(1) In that case, Portfolio Armor would round down the number of shares you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with nine of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 821 shares would be protected against a greater-than-18% loss.
(2) To be conservative, Portfolio Armor quoted that cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.