Time To 'Put' On Some Portfolio Insurance

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 |  Includes: SPY
by: Common Cents

Most investors desire to smooth out the bumps in the road of stock market volatility. Most often this is done through diversification. Bonds have often played a key role in providing this portfolio diversification. However, with rates so low it seems mathematically challenging for bonds to provide this kind of protection during the next market pull back. Many sophisticated investors at hedge funds, pension funds, endowments etc. look to smooth out the bumps in the stock market not just through asset class diversification but also more directly by having some short positions in their portfolio. More specifically, being short the market while long their favorite equities. This provides some insurance against a market downturn that will serve to dampen volatility. Individual investors may want to consider doing this within their portfolio as well.

There are several ways to implement this strategy. One of them is to buy puts or vertical put spreads against an index. Some of the advantages of this approach are that they are very liquid and require little capital. An analogy might be "term insurance" (i.e. buy term and invest the difference). However, one of the drawbacks of this approach is an investor has to pick a specific target price and date. No doubt it can be challenging to decide when to put this term insurance in place, and what to buy. This article discusses why now is a good time to buy and makes some suggestions on what insurance to buy.

Why buy now?

It seems now is a good time to buy for a few reasons

  • Volatility is down. The VIX is at its lowest level in six months. That makes option prices (and insurance) cheaper. The old adage of "buy insurance when you can, not when you have to" seems to apply.

  • Markets are near their 200 day moving average. This level can provide a pivot point for the market to move either up or down.

  • Earnings season is starting. Disappointments would likely drive the market lower.

  • The holiday quiet news period is over. There is certainly always the risk of some bad event occurring in Washington, Wall Street, Europe, the Middle East, etc. However, these days it seems the media also needs to fill the airwaves with some "crisis" to keep the eyeballs watching. Hence there seems to be the potential for another “crisis” in q1.

What to buy?

  • Domestically, the S&P500, Nasdaq 100, and Russel 2000 are all good potential broad indexes to considering buying puts against. It seems the S&P 500 might be a good choice right now. It is the index with the largest exposure to financials. It would seem that the biggest risk of a market pull back might align with another issue in this sector. Conversely the Nasdaq index is dominated by companies like Apple, Google,etc. Those might not be the right companies to bet against right now. Lastly, the Russsel 2000 is the most US focused. It seems the US economy might by the least bad of the developed world, and hence the strongest index.

  • There are obviously many, many combinations of strike prices and dates to consider. There are many theories on which ones are best to buy. I try to keep it a little simpler. Either buying a near term date to profit from a normal correction and/or a longer-term date to profit from a bear market pullback. Specifically I am looking at

    • The February SPY $128- $122 put spread. As of the time this article was written this the spread is trading for $1.44 or one quarter of the spread. It achieves maximum return if the index falls about 5% in the next month (or just half a normal correction)

    • The June SPY $120 - $110 put spread. As of the time this article was written the spread is trading for about $2.00 or one fifth of the spread. It achieves maximum return in the index falls about 15% in the next half a year (or about half a normal bear market.)

Each spread costs less then $200 to do one time, so an investor not familiar with this type of approach can try this without risking huge amounts of capital. Conversely, an investor could put on the spread as many times as they like. Obviously each contract provides more portfolio protection, but will also be more of a drag on performance of the remainder of the long portfolio if the market rises from here.

In summary, any investor looking to smooth out the volatility of an equity portfolio may want to consider put spreads as one of many strategies to use. Perhaps now is the time to “put” some insurance in place.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.

Additional disclosure: This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.