When Smart Money Picks Up Cheap Insurance

About: SPDR S&P 500 Trust ETF (SPY), Includes: CS, DIA, TLT
by: David Pinsen

Wednesday's "What'd You Miss" on Bloomberg TV highlighted the recent divergence between the S&P 500 and the VIX, which suggests investor complacency as the market hovers near an all-time high.

The FT's John Authers called it "irrational equanimity" and relayed market strategist Peter Kenny's admonishment that this is when "smart money buys cheap insurance."

We look at a way of doing that.

Image via Bloomberg TV.

S&P 500 Near All-Time High While VIX Hits Low

On Wednesday's episode of Bloomberg TV's What'd You Miss, Abigail Doolittle noted the divergence between the S&P 500 index trading near an all-time high while the CBOE's VIX "fear gauge" touched its 52-week low intraday. The Financial Times' senior market commentator John Authers noted it too, and, in a play on Alan Greenspan's famous phrase from 20 years ago ("irrational exuberance"), wondered if it was an example of "irrational equanimity."

Screen capture via Twitter.

In his FT article that tweet links to (which might be paywalled if you don't have an FT account), Authers quoted Mandy Xu, a derivatives strategist at Credit Suisse (NYSE:CS), and Peter Kenny, senior market strategist at Global Markets Advisory Group:

The difference between anticipated fluctuations in the VIX and realized ones climbed this week to a one-year high "in a sign volatility may pick up significantly in the new year" according to research by Mandy Xu, a derivatives strategist at Credit Suisse.

Mr. Kenny echoed that sentiment, saying that "it is precisely at these depressed levels that smart money picks up cheap insurance."

Picking Up Cheap Insurance

With Mr. Kenny's suggestion in mind, let's see how much it could cost to insure a $1,000,000 stock portfolio against an extreme market drop over the next several months.

Note: we are not predicting an extreme market drop.

We have no idea what the market will do over the next several months. The point of this is buy some protection while it is cheap to do so. If the market keeps hitting new highs next year, you'll participate in that upward move, minus the <1% of your portfolio you paid for insurance.

Hedging A $1,000,000 Portfolio Against Market Risk

Earlier this month, we looked at protecting a half million-dollar portfolio against market risk using a hedge on the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), but this time we'll use the SPDR S&P 500 ETF (NYSEARCA:SPY) and a larger portfolio. If you'd like a refresher on hedging terms first, see the section titled, "Refresher On Hedging Terms," here.

Pick A Number Of Shares

Since we're using SPY as our proxy ETF, in order to hedge a $1,000,000 equity portfolio against market risk, you would want to hedge an equivalent dollar amount of SPY.* Since SPY closed at $225.82 on Wednesday, you could divide your equity portfolio dollar amount, $1,000,000 by $225.82, to get 4,428. Note that 4,428 isn't a multiple of 100, and that options contracts each cover 100 shares. More on that below.

Pick Your Decline Threshold

As a shorthand, we call the maximum decline you are willing to risk your threshold. Generally, the larger that number is, the less expensive the hedge and vice versa. In some cases, a threshold that's too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge. A starting point to consider is this idea from Dr. John Hussman:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So we'll use that for our example here.

Find the Optimal Puts

The idea here is to find the least expensive put options to protect 4,428 shares of SPY against a greater-than-20% decline. You can use the process we outlined here to work that out manually, but we used the Portfolio Armor iOS app. We actually tried this two ways: once, using 4,428 shares, and a second time rounding up to 4,500 shares. It turned out that hedge in the second case was less expensive in dollar terms, so we'll show that one below.

First, you'd enter ticker, number of shares and the largest drawdown you're willing to risk (your threshold):

Screen capture via the Portfolio Armor iOS app.

Next, you'd tap the "Done" button and get the optimal puts:

Screen capture via the Portfolio Armor iOS app.

The cost, as you can see above, was $6,885, or 0.68% of your equity portfolio's value, to hedge out to mid-June. A couple of points about this hedge:

  1. To be conservative, the cost was based on the ask price of the puts. Since you can often buy puts at some point within the bid-ask spread, you could have probably purchased these puts for less on Wednesday.
  2. This was one of those cases where it was cheaper to hedge the next-highest multiple of 100 shares, but it's worth running the numbers both ways to be sure.

How This Hedge Would Protect Your Portfolio

If SPY drops more than 20% - if it drops 20.5%, 30%, 40%, or even more - the put options above will rise in price by at least enough so that the total value of a $1,000,000 position in SPY plus the puts will have only dropped by 20% in a worst-case scenario.

The hedge will offer that level of protection up until it expires in mid-June, but if there's a significant decline in the market in the near future, it may offer more protection than that due to time value.

Hedging A Portfolio Of Stocks And Bonds

The example above is simplified in that we've assumed that the non-cash part of our hypothetical investor's portfolio is entirely invested in stocks. But what if he had some bonds or bond mutual funds? In that case, we could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, we'd use one per each asset class. So, for example, if 60% of the investor's assets were in blue chip US stocks, and 40% in Treasury bonds, we might scan for optimal puts for a $600k position in SPY and then scan for optimal puts for a $400k position in the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).

*We're assuming here that your stock portfolio is going to be highly correlated with SPY in the event of a correction. If you want to complicate this in the hopes of adding precision, you could calculate the beta of your portfolio first, and then adjust the number of SPY shares accordingly. But if precision is really your goal, you might consider the hedged portfolio method, where each security in a concentrated portfolio is hedged directly, rather than via a proxy ETF as in the example above.

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.