Protecting Your Portfolio With Put Options On SPY

Dec. 11, 2019 9:17 AM ETSPY28 Comments13 Likes
David Pinsen profile picture
David Pinsen
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Summary

  • Demand for hedging against a sharp drop in the S&P 500 has gone up recently, as Michael Mackenzie noted in his FT column over the weekend.
  • For readers looking to add protection to their own portfolios, I show a simple way of doing so using put options on SPY.
  • I close by noting a drawback of this approach.
  • Looking for a helping hand in the market? Members of Bulletproof Investing get exclusive ideas and guidance to navigate any climate. Get started today »

The trade war between the United States and China continues to be a risk factor for the market, as Michael Mackenzie noted in this weekend's Financial Times (image via Binmei.Jp).

A "Strong Appetite" For Downside Protection

In his "Long View" column in Saturday's Financial Times ("Investors Ignore The Weaponization Of Tariffs At Their Peril" - paywalled here), Michael Mackenzie noted there was a "strong appetite" for downside protection now:

Lisa Shalett at Morgan Stanley Wealth Management notes that "more than a third of the companies have year-over-year earnings contractions," and warns: "Profit pullbacks of this breadth in 2002 and 2009 coincided with broader economic recessions."

Not surprisingly, there remains strong appetite for buying insurance over the next year via equity options, with one measure of 12-month demand at a new high for the year and just shy of its record peak set in late 2017.

For readers looking to buy insurance for their own portfolios, I show a simple way of doing so using puts on the SPDR S&P 500 ETF (SPY) below. I'll close by pointing out a drawback of this approach.

Protecting A $500k Stock Portfolio With SPY

Here’s a simple way of protecting a stock portfolio against market risk using optimal, or least expensive, puts on SPY. For the purposes of this example, I’ll assume your portfolio is worth $500,000, that it’s closely correlated with SPY, that you have enough diversification within it to protect against stock-specific risk, and that you can tolerate a decline of up to 20% over the next few months (if you have a smaller risk tolerance, you can use the same approach entering a smaller decline threshold; similarly, if you have a larger or smaller portfolio, you can adjust Step 1 accordingly).

Step 1

Divide $500,000 by the current price of SPY, which was $314.87 as of Friday’s close, to get 1,588 (rounded).

Step 2

Scan for the optimal, or least expensive, puts to protect against a >20% decline in 1,588 shares of SPY over the next several few months (the screen captures below are via a hedging app, but you'd like to do this manually, I described that process here).

Optimal hedge on SPY

Note the cost here: $6,885, or 1.38% of portfolio value, which was calculated conservatively, using the ask price of the puts (in practice, you can often buy options at some price between the bid and ask prices).

Step 3

Round up the number of SPY shares to the nearest 100 and repeat step 2.

Optimal hedge on SPY

Note that, in this case, it was cheaper to hedge rounding up to the nearest round lot: The cost was $4,416, calculated conservatively again, at the ask. That’s about 0.88% of a $500,000 portfolio.

Wrapping Up: A Drawback Of This Approach

In addition to showing dollar cost and cost as a percentage of position value, the screen captures above also show annualized cost as a percentage of position value. In the second, less expensive, example, that annualized cost is 1.65%. A drawback of this approach is that this cost will act as a drag on your portfolio's returns if the market keeps going up. If your portfolio is closely correlated with SPY, you can expect to lag it by approximately 1.65% over the next 12 months assuming the market goes up over that time frame, you add new hedges of similar time to expiration just before these expire, and the cost is similar to what you paid here.

Generating Better Returns While Hedging

This article described a way to hedge against market risk using puts on SPY, and noted that your returns in an up market will lag SPY by your cost of hedging. To beat SPY in an up market while hedging, you need to own names that can outperform SPY. The top ten names I have presented in my Marketplace service each week since June of 2017 have outperformed SPY by 2.52% annualized so far, and can all be hedged in the same way I hedged SPY above. You can sign up for a free two-week trial to the service here

This article was written by

David Pinsen profile picture
18.83K Followers
I developed the hedged portfolio method of investing at Portfolio Armor, and I run a Marketplace service at Seeking Alpha based on it called Bulletproof Investing.
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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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