Another Look At Hedging Against A 50% Market Drop

by: David Pinsen

In an article last month on ("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 (NYSE:DM), Altrisource Portfolio Solutions SA (NASDAQ:ASPS) and Lender Processing Services, Inc. (NYSE:LPS).

A Problem With Bradford's Hedge Idea

Bradford's logic there was 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 also tank.

As we noted in an article at the time ("Hedging Against A 50% Market Drop"), betting on those stocks to rise when the market crashes sounded 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 Wal-Mart (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, and 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 (KFT), and you'd like to know how to hedge that position against a greater-than-18% loss. Using Portfolio Armor (which is available on the web 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)

The example above mentions a stock, but you can hedge market risk in a similar way. Let's walk through an example.

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 ($117.97, as of Friday's close) = 847.7, which we've rounded up to 848 and entered in the "Shares Owned" field below.

Step 3: Enter a decline threshold

Fifty percent seems like a pretty steep decline to expect. 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: Tap the blue button

A moment after tapping the blue 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 March 16th, 2012. The cost of this protection on a $100,000 position would be $680, or 0.68% 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 8 of the put option contracts that would slightly over-hedge the 800 shares of SPY they cover, so that the total value of your 848 shares of SPY would be protected against a greater-than-49% decline.

Note also that the cost is greater this time, at 0.68% of position value, than it was when we ran this exercise last month, when it was 0.175% of position value. Two reasons for that are that volatility was higher Friday than it was at the end of last month, and that in this case the cost is based on options with approximately seven months to expiration, and last month it was based on options with approximately six months to expiration.

(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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.