David Pinsen
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That Was The Crash, Dummy [View article]
That Was The Crash, Dummy [View article]
You are right that holding cash constitutes an opportunity cost if the market goes higher, and that (unless you are able to roll them before expiration), protective puts would expire worthless in such a situation. But given the current, low cost of hedging against market risk with optimal puts, the hedged investor may still be better off in this case. Consider the following example.
Let's say there are two investors, Investor 1 and Investor 2, and Investor 1 decides to hedge against a greater-than-20% drop in the Dow between now and late December using the current optimal puts for that. Adjusting for the odd lot a $100k position in DIA includes at the moment (the app does this automatically) this would cost him 0.74% of his portfolio (that cost is calculated conservatively, assuming he bought the puts at the ask price; as you know, an investor can often buy puts for less, i.e., some price between the bid and the ask). Let's say Investor 1 has a $100k portfolio, so after buying those puts he has $99,202 in equities and $798 in his protective puts.
Now, let's say Investor 2 also has a $100k portfolio, and rather than buying protective puts to hedge, he holds a 50% cash position. So he has $50,000 in equities and $50,000 in cash.
What happens to both investors' portfolios if the market appreciates by 10% between now and late December? Let's assume, for simplicity's sake, and to be conservative, that Investor 1's puts expire worthless. His $798 in protective puts is now worth $0, and his $99,202 in stocks is now worth $109,122. So, his total portfolio is now worth $109,122. Meanwhile, Investor 2's $50,000 in stocks is now worth $55,000, and his $50,000 in cash is worth perhaps $50,200 (given the current paltry money market rates) so his total portfolio might be worth $105,200. Of course, if the market were flat over the same time period, the investor holding the large cash position would come out a little ahead.
I also agree that the market today is not analogous to the Nasdaq in 2000 or the Nikkei in 1989, but I think it may be analogous to the market in 2007. The market is significantly overvalued according to some measures (such as Tobin's Q Ratio, for example), and there are other troubling indicators, such as brokerage margin debt being at record levels.
Also, if you believe the current bull market is a cyclical one within a secular bear market (as I do), then you may be concerned that the cyclical bull market has gotten a little long in the tooth. And I believe there is utility in hedging against steep declines when it's inexpensive to do so, even if it may be possible to eventually recover from those declines by gritting it out, as it were. Being hedged during a bear market doesn't only limit losses but give an investor dry powder (the cash value of his appreciated hedges) that he can use to pick up bargains.
That Was The Crash, Dummy [View article]
You're right that an investor is faced with decisions about expirations and strike prices when hedging with protective puts, but our research suggests that options with approximately six months to expiration tend to offer the best combination of cost, liquidity, and convenience from the investor's perspective, so our app aims for those. The app also shows the investor the specific options which will give him the level of protection he wants at the lowest possible cost, so it simplifies the process of hedging.
One benefit of hedging is that it can obviate the need to hold a large cash position. There are, as you know, opportunity costs to holding large cash positions.
As for suggestion that "corrections tend to be short lived and recoveries tend to be certain," this is generally true during secular bull markets. If you believe we are in a secular bull market now, that is reasonable advice. But I believe we are in a secular bear market that began in 2000, and won't end until valuations are much lower than they are today.
Unhedged investors who were long the Nikkei in 1989 or the Nasdaq in 2000 have been waiting a long time for those indexes to recover their all-time highs.
That Was The Crash, Dummy [View article]
Checking the numbers as of today, it's even cheaper (slightly) to hedge now.
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