At the risk of being labeled a perma-bear, I will again repeat that it's time for investors to revisit their hedging strategies. I won't go into the reasons here. Instead, I'll show you how you can cope with the risk of a 20% to 70% drop in the stock market without being crushed. This strategy can't save you from all losses, but it can keep those losses small, without notably affecting your upside in case this prognosis is wrong.
Let's assume you've got around $100k invested in a mix of growth and income companies paying you a great dividend - earnings you expect to be around 3% a year, with good prospects of moderate long-term growth and little chance of bankruptcy.
If you are in your 60s, 70s, or 80s, you might not be so sanguine about waiting out a 60-70 percent drop in the market.
So here's how you can use options on a major index in order to sleep well at night.
First step: sell about $4,000 of your least performing investments in order to raise cash for this hedge. The hedge will cost you around $3,700 or 3.7% of your portfolio and will give you profits in a large drop in the markets as well as a continued market rise. It will limit your losses to a tolerable 6-8% in a moderate 10% to 20% drop in the markets.
Invest your money in what I label as a lopsided butterfly. Specifically, using today's market values (April 15, 2018), you could spend $3,739 to establish the following positions:
|SPY DEC. 20 '19 210 Put||8||$7.68||$6,148|
|SPY DEC. 20 '19 100 Put||10||$0.39||$390|
|SPY DEC. 20 '19 150 Put||15||$1.87||-$2,799|
So how would this options play be affected by different market outcomes? Take the following 3 graphs with a pinch of salt. The first shows possible value ranges at 6 months, the second at 12 months, and the third most important graph at expiration of the options contracts on December 20, 2019, roughly 22 months out from today.
Why the pinch of salt? Because we've not varied the volatility from its present value. This would introduce too many variables and just confuse the reader. True, on stark market drops, the volatility is likely to increase. Since this particular option setup is vega positive, it benefits from a rise in volatility. So actual profits would likely be higher than shown in the graphs and in the subsequent summary table. On a rising market, volatility is likely to decrease and the losses would be the same as shown in the tables below.
Our intention is to hold the options hedge to term, so the intermittent graphs are only important to give the investor an idea of how the options portfolio's value is likely to fluctuate over time. If you know what could happen, you're unlikely to bail out of the hedge too early.
|Market Performance S&P 500||-40%||-30%||-20%||-10%||0%||+10%||+20%|
|After 6 months||+16%||+12%||+5%||+0%||-3.7%||-3.7%||-3.7%|
|After 12 months||+17%||+12%||+5%||0%|| |
|After 22 months||+40%||+35%||+10%||-3.7%||-3.7%||-3.7%||-3.7%|
Now let's map the effect of various market scenarios on your growth and income portfolio. We are assuming that these holdings drop a little less than the overall S&P 500, but also rise a little less. Also, remember the assumption that you now have 97% of money in dividend paying stocks paying 3% dividends
|Core Portfolio Value||-35%||-30%||-18%||-5%||0%||+10%||+15%|
(22 months return)
Total Return Entire Portfolio
Adding in Options Return
As you see, this hedge provides great protection against a big drop in the market, allowing you to reap around 10% profits even in the case of a market meltdown. Yet, it still does well in a market rise. Unfortunately, the trade-off is in the case of a small market swoon in the 0% to -20%. Here you lose around 3% overall, including your dividend income.
For most investors though, that is something they can live with.
Disclosure: All investments involve risk. In particular, options hedges are complicated products and should only be undertaken by knowledgeable investors. This is not a solicitation to buy or sell.
Disclosure: I am/we are long 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: We currently hold similar hedges to those mentioned in this article for our customer portfolios.