A Timely Test Of The Ultimate Hedge Against A Market Crash

Nov. 8.12 | About: SPDR S&P (SPY)

Either the market didn't like the results of the election Tuesday or now that it's over, investors have switched their focus to fears of the fiscal cliff or a European melt-down (or both). SPY was down $3.24 (2.3%) Wednesday and the Dow was down 280 points.

This article discusses two ways to handle mini-crashes like we experienced Wednesday as well as larger melt-downs that might occur in the future.

First, the high inverse correlation between VXX and the market can be used as a hedge against a market melt-down. Last week I wrote a Seeking Alpha article about using options on VXX entitled The Ultimate Hedge Against a Market Crash. The basic premise of the article was that VXX was strongly inversely correlated to the market, and that an options strategy which was long VXX could provide good protection against a market melt-down.

Rather than simply buying VXX (a deteriorating asset because of contango), the best strategy in my opinion is to set up a combination of option positions such as those I described in that article. While any number of option positions might be used, the key point is to create a portfolio that is long VXX (i.e., positive net delta so it gets worth more when VXX moves higher) which is also positive theta (so that each day that nothing happens, the portfolio gains a bit in value).

Less than a week after I wrote this article that premise was put to the test with Wednesday's mini-crash. While the market fell 2.3%, VXX rose 7.6%, demonstrating the inverse correlation. The Crash Control portfolio I set up as a hedge against a crash gained 18% Wednesday, and is poised to gain at an accelerated rate if the market continues to fall. I feel totally vindicated.

I apologize to the many people who have written to me complaining that the combination of calendar spreads, a butterfly spread, and uncovered long calls on VXX was extremely complex. It was the only way I could figure out a way to make certain that a gain would be made if VXX fell as much as 14% in six weeks as well as making greater gains if it went up because of a market crash.

These complex spreads resulted in the risk profile graph that looked like this :

Click to enlarge

This is a $4300 (starting value) portfolio that should make a gain of some sort if VXX ends up at any price higher than $30 (it was $34.50 when I established these positions in my Crash Control portfolio). VXX shot up $2.62 Wednesday to $36.95. The portfolio gained $870 Wednesday.

The graph shows that the most serious gains come about if the market continues to fall and VXX rises. If VXX doubles as it did last summer when Greece appeared ready to go under, this portfolio should more than double in value.

The second way to contend with market drops works best with mini-crashes like we experienced Wednesday. It involves buying out-of-the-money lower-strike butterfly put spreads on SPY (as a surrogate for "the market"). I have added them to all three options portfolios I carry out using SPY as the underlying. Two of these portfolios trade Weekly options and one trades the monthly series (both designed to collect premium decay). With option prices as low as they have been for the last few months, these butterfly spreads are unusually cheap to buy, and they provide peace of mind against a moderate drop of about $4 in the price of SPY each week.

Last week, with SPY trading about $142, I bought weekly put butterfly spreads at the 141 - 138 - 135 strikes, paying only $36 per spread (it has a maximum value of $300 if the stock closes at $138).

If you wanted the same protection at Wednesday's lower price of SPY, Thursday you could buy a put butterfly spread expiring November 16th at the 139 - 136 -133 strikes to get similar protection for next week. It would cost about $50 (higher than last week's cost because of VIX moving up Wednesday).

Even at $50, the butterfly would cost less than third of what you could collect in week by selling an at-the-money SPY 140 put (about $175 at Wednesday's close) as part of a calendar or diagonal spread. Seems like cheap insurance to me.

There was no surprise that our bearish portfolio (called Big Bear) did well Wednesday (it was up 18%), but the other two SPY portfolios are delta-neutral, and they both did well as well (up 3% and 6%) while the market fell over 2%. All thanks to those downside butterfly spreads.

It has been difficult to collect much premium decay by selling short-term SPY options lately while option prices have been so low (VIX has languished between 14 and 17 for quite a while, at least until today when it moved above 19). I have found that adding a directional spread (the butterfly spread) covers a downside move in the market and could end up being far more profitable than depending on premium decay as the only source of weekly or monthly gains for these portfolios.

Disclosure: I am long VXX, 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.

Additional disclosure: A am long VXX options and delta-neutral or negative-delta SPY options.