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Hedging Stock Market Risk: Part 2

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Robert Boslego
Robert Boslego
Portfolio strategy, oil & gas, medium-term horizon
Summary

Stock market may drop precipitously if a Democrat 'socialist' is elected president, according to one hedge fund manager.

Stock market risk can be hedged with covered calls.

BMX index provided superior risk-reward results during 1986-2019.

But maximum drawdown was still too high.

I pointed out in Part 1 of this series that the bull run in the stock market is aging. Sooner or later, the market is going to turn south and stock portfolios will suffer.

“If a Socialist is Elected, the Market will sell off BIG,” Steven Gidumal, managing partner of Virtus Capital, said in a slide presentation. Wall Street seems wary of a socialist being elected, and that may have been the key reason Bloomberg entered the race, to try to prevent that from happening.

“Pick a Socialist - Bernie, Liz, Pete. etc. and the Market would sell off,” between 30 and 50 percent, Gidumal said. I would add that the market would start to price in a socialist being elected based on the polling much earlier than the election in November.

For those with long investment time horizons, that may not be such a worry. But for those in retirement and dependent on income from a portfolio, it may be worthwhile to study how to hedge downside risk while still being set up to profit, if the market continues to rise.

In Part 1 of this series, I presented analyses of using put options to hedge downside risk. I showed that a strategy based on systematically buying puts could provide a better risk-reward result than simply staying long the market, as well as limiting the maximum drawdown from peak (my preferred risk measure). However, I concluded that the maximum drawdown was still too high for many investors.

In Part 2, I will examine how using covered calls can benefit investors. By selling calls, the investor becomes “the house.” By providing insurance, sellers of calls should expect to “win” (make money) over time. Those profits can cushion the times in which large losses occur.

SPX Risk and Return

SPX is an index of the S&P 500. That means that it is calculated directly by the value of the underlying stocks. SPY is an ETF, which means its price is set by buyers and sellers of the ETF. Note that indexes are not investable.

CBOE provides a history of the index from July 1986 through July 2019. Over that period, an initial $1,000 investment would have increased to $12,063.

There are many techniques used to measure investment risk. The one I find most important is maximum drawdown from peak. The reason is that it shows how much (percentage) an investment had lost from its “high watermark.” Based on investor behavior and hedge fund practice, this is a risk tolerance limit wherein an investor would consider exiting the investment. In the hedge fund industry, this limit is typically set at 30 percent; i.e., any “lock-up” of capital is released if that limit is reached (or exceeded). The best investments are those in which an investor can remain for the long term rather than locking in losses by exiting.

For SPX, the maximum drawdown from peak over this period was 57 percent on March 9, 2009. This is obviously a very large loss which is why risk management is needed.

Introduction to Buy-Write Strategies

A "Buy-Write" strategy, also known as a covered call, generally is an investment strategy in which an investor buys a stock or a basket of stocks, and also writes covered call options that correspond to the stock or basket of stocks.

Buy-Write strategies provide option premium income that can help reduce downside moves in an equity portfolio. However, Buy-Writes often under-perform stocks in rising markets.

For example, some Buy-Write strategies significantly outperformed stocks in 2000 when stock prices fell, but Buy-Writes tended to under-perform stocks in the years 1995 to 1998 when the S&P 500 rose by more than 20% per year.

Buy-Write strategies have an added attraction to some investors in that Buy-Writes can help lessen the overall volatility in many portfolios.

Click here for a link to studies of buy-write strategies.

The Cboe S&P 500 BuyWrite Index (BXMSM)

The Cboe S&P 500 BuyWrite Index (BXM) is a benchmark index designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index. Announced in April 2002, the BXM Index was developed by the Cboe in cooperation with Standard & Poor's.

The BXM is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index (SPXSM) "covered" call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.”

Calculating the return of BMX over the same period as above, the value of BMX rose to $15.932. The return of SPX alone was 24 percent lower.

The maximum drawdown of BMX was 40 percent. The maximum drawdown of SPX was 42 percent higher.

The question becomes what if I just reduce the size of my SPX portfolio to reduce the maximum drawdown to that of BMX? To reduce the maximum drawdown to 40 percent, the SPX portfolio would have to be reduced to 64 percent of its initial size. But that would reduce the final value of the SPX portfolio to $5,573, which is only 35 percent of the ending value of BMX.

I therefore conclude that BMX offers a better risk-reward tradeoff if maximum drawdown is used as the risk criterion. However, I also conclude that 40 percent is still too high of a loss for most investors to tolerate.

Conclusions

Hedging with a Buy-Write strategy offers an improved risk-reward trade-off based on the data series tested above. However, the BMX index still resulted in a maximum drawdown during the financial crisis of 2008-2009 than would be tolerable for many investors. And so I will present the findings of combining put and call strategies in Part 3.

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.