Protection For A Correction: A Hedging Strategy For Long-Term Dividend Investors

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Includes: DIA, IWM, JNJ, KO, QQQ, SPY, VXX, VZ
by: Parsimony Investment Research

Summary

If you prepare for the worst, you will always have a strategy in place for whatever the market throws at you.

Investors often forget that a significant market correction can wreak havoc on even the highest-quality, dividend-paying stocks.

A protective put hedging strategy is something every long-term dividend investor should have in their toolbox.

"The only thing we have to fear is fear itself." - Franklin D. Roosevelt

We wish we knew when the market was going to correct. It would be so much easier to invest, wouldn't it? Unfortunately, none of us have a crystal ball though and we are often at the complete mercy of Mr. Market.

As shown in the graph below, the market has been a little schizophrenic over the past 6 months.

The S&P 500 corrected over 12% in late August 2015 - then rallied back 13% by the beginning of November 2015.

Now we are down over 10% again from that recent peak!

That said, knowing that the market is going to throw us 7 different kinds of smoke, it's prudent to have a strategy in place to protect your portfolio from a major correction.

Let us be clear here...we are not saying that a major correction is coming. Just don't ignore that fact that it is possible. It's always possible.

The August 2015 lows have held as support thus far, which is very positive. However, if we break through that level it could get ugly in a hurry. Just keep your eye on those levels.

If you prepare for the worst, you will always have a strategy in place for whatever the market throws at you.

Why Hedge?

First and foremost, it's important to remember that market corrections happen. As a matter of fact, we would add market corrections to the list of things in life that are guaranteed. Just like death and taxes, market corrections are a way of life. That said, investors need to EXPECT, and more importantly, PLAN for major corrections.

Investors often forget that a significant market correction can wreak havoc on even the highest-quality, dividend-paying stocks. It's actually difficult to find a dividend stock that didn't experience a decline of at least 30% during the 2008 recession. Below are the 2008 maximum drawdowns for some widely held "defensive" dividend stocks:

  • Coca-Cola (NYSE:KO): -40.6%
  • Johnson & Johnson (NYSE:JNJ): -34.4%
  • Verizon Communications (NYSE:VZ): -42.5%

A portfolio hedge could have reduced these losses significantly... without having to sell your stock or give up your dividend. Investors can plan for a market correction by taking the necessary steps to hedge their portfolio. In our opinion, a protective put hedge strategy is the easiest and most cost-effective way to hedge a portfolio.

The Cost of Protection

The CBOE Market Volatility Index (VIX) is a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30-day period.

As shown in the graph above, the VIX closed at 23.38 last week, which is higher than the long-term average but certainly not near peak levels. In theory, when expectations of future implied volatility are low, it is a contrarian indicator that investors are overly optimistic about the future. In other words, when the VIX is low, there isn't enough "fear" in the market. Historically, market corrections tend to spawn when implied volatility (or fear) is low. Note: iPath has an ETN that tracks short-term VIX futures, iPath S&P 500 VIX (NYSEARCA:VXX), which is also a good proxy for future implied volatility.

That said, the best time for an investor to purchase protective puts is when the cost of protection is low. Implied volatility is one of the main variables in option pricing models and as implied volatility declines, so does the price of the option (or the cost of the hedge).

Protective Put Strategy Overview

The main purpose of hedging your dividend portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income intact. As we said above, we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio.

We like to use options on the S&P 500 ETF (NYSEARCA:SPY) for our protective put strategy. Remember that we are only trying to "hedge" the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Note: If you are unfamiliar with options, there are some great free websites out there to educate yourself (like The Options Industry Council).

Hedging 101 (Step-by-Step)

As we have previously discussed, we believe that the next 3-6 months will remain volatile. That said, since we are so close to breaking through our main level of support, we feel that now is as good of a time as any to start implementing a short-term "hedge" for your portfolio.

Below is a step-by-step procedure that we follow when implementing a protective put strategy. Hopefully, this will help you implement a similar strategy for your own portfolio.

Step #1: Determine How Many Puts to Buy

Every portfolio is different, but the weighted average Beta of your portfolio is a good metric to use to estimate your portfolio's general market exposure (i.e., systematic risk). For example, if your portfolio Beta is 0.50, the volatility of your portfolio should theoretically only be half that of the general market (i.e., if the market declines 1%, your portfolio should only decrease 0.5%).

For example, let's say you have $100,000 of long stock exposure, with a weighted average Beta of 0.75. Theoretically, if the S&P 500 declines 10%, your portfolio should only decline 7.5%. That said, you would need to buy approximately 4 SPY puts to hedge your portfolio:

Underlying Value of 1 SPY Option Contract:

$187.88 x 100 = $18,788

Contracts Needed to Fully Hedge Portfolio:

$100,000 / $18,788 = 5.32 Contracts

Beta-Adjusted Contracts:

5.32 x 0.75 = 3.99 Contracts

Step #2: Determine a Strike Price and Term

In general, we prefer shorter-term options (less than 4 months until expiration) over longer-term options and we prefer "in-the-money" options over "out-of-the-money" options. We have these preferences because we try to limit the "time value" exposure in our protective put. In other words, we want as much "intrinsic value" as possible in our put option. For put options, the intrinsic value is the difference between the strike price and the underlying's stock price and we want the value of our put option to track as closely as possible to the underlying change in the price of SPY.

Choosing a strike price and expiration date for your put option is ultimately a personal decision. Some investors may prefer longer-dated options because they have to be "rolled" less frequently or they may prefer "out-of-the-money" options because they are less expensive. However, these decisions will ultimately affect both the cost of the hedge as well as the degree of protection that the protective put will provide. So it is critical that you understand the trade-offs of these decisions before implementing this strategy.

That said, we suggest targeting the May or June 2016 Put options, which would give you 3-4 full months of protection. As expiration approaches, you can reassess the market to determine whether or not you want to roll the position for another few months.

As far as strike price goes, we try to purchase a strike with a Delta of .50-.60. Without getting too technical, an option's delta can be used as a proxy for the probability that the option will finish in-the-money. In other words, an option with a delta of .60 theoretically has a 60% chance of finishing in-the-money. The higher the delta, the greater the intrinsic value (and the greater the cost)... so there is definitely a cost/benefit tradeoff when picking a strike price. That said, we recommend targeting a strike price in the $190.00 to $194.00 range for the May or June 2016 put options.

Step #3: Determine How Much Protection You Think You Need

Timing is everything when using options and it's important to estimate how low you think the market could go (over the term of the option period) so that you will be properly protected. The obvious tradeoff of buying a protective put for your portfolio is...cost.

The key takeaway here is that you shouldn't pay for what you don't need.

You can offset part of the cost of a protective put by selling an out-of-the-money put with a lower strike price (and the same expiration). Essentially this would create a "put spread," where you would limit your maximum profit (but it will also lower your cost of protection).

For example, since we think it is possible that the market could drop another 10% in the next 3-4 months (which would equate to SPY falling to approximately $170.00), we would recommend selling the May or June 2016 put that has a strike price of $170.00. In other words, this spread position will protect you from a market correction up to 10.0%. However, if the correction is greater than that (i.e., if SPY drops below $170.00), your portfolio will be unhedged. This is why it's important to really think about how low you think the market could go before you decide whether or not you want to sell an option with a lower strike to reduce the cost of your hedge.

Summary

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. A hedge is essentially an insurance policy for your portfolio and whether or not you decide to hedge your own portfolio will depend on your specific market outlook and risk tolerance.

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

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.

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