The Ultimate Protection Hedge Against A Market Crash?

Includes: DIA, ETN, SPY, VXX
by: Terry Allen

Every once in a while the market crashes. Like death and taxes, it is inevitable. I have come up with a way to relieve that nagging fear in the back of your mind that maybe another 2008-like crash may come along tomorrow and decimate all the wonderful dollars you have accumulated in your retirement account for the past several years.

When people talk about "the market" they usually are referring to the S&P 500 (NYSEARCA:SPY). Or maybe the Dow Jones Industrial Average (NYSEARCA:DIA). In either case, when one of these ETFs crashes, so do just about every other stock and mutual fund out there. Unless you had the foresight to be short some of those stocks, you inevitably suffer when the crash occurs, as it will, and you may have to wait several years before you get back to where you were before that awful day came along.

One of the most popular ways to protect against a market crash is probably VXX, an Exchange Traded Note (ETN) based on the futures of VIX (the so-called "fear index" of SPY option volatilities). Pundits have argued that putting 10% of your money in VXX will protect you against all your stock and mutual fund investments if there is a market crash (my calculations show that 20% is closer to the amount you need to buy, but I agree with the idea that it does offer market crash protection). That is the good part of VXX.

The bad part of VXX is that in the long run, it is about the worst investment you could possibly make. Check out its graph since its inception at the beginning of 2009 (click to enlarge images):

Have you ever seen any stock fall this consistently for so long? I think it has fallen over the last three years more than any other stock in the world that is still being traded, from a split-adjusted $1800 to its current $35. On two occasions in those three years, they have had to make a 1 - 4 reverse split of the ETN so that it would have enough value to be worth buying. Just last month it had dropped to $9 so they performed another reverse split and boosted the stock up to $36.

The reason that VXX consistently falls when the market fluctuates only moderately or moves higher is that every day, the managers of the ETN must take off (sell) shorter-term futures on VIX and add on (buy) longer-term futures. Since longer-term futures are almost always higher than short-term futures, they are almost always buying high-priced entities and selling low-priced ones. It is a condition called contango, and it is what happens about 90% of the time. The result is that VXX falls about 6% - 8% every month that nothing exceptional occurs in the market.

The danger of selling short such a dog (which I have successfully done many times, by the way) is that you always take a big risk that the market will crash, VIX will skyrocket, and short-term volatility futures will become greater than long-term volatility futures (a condition called backwardation, the opposite of contango). When this happens, VXX shoots higher extremely fast. In the summer of 2011 when the European scare escalated, VXX shot up from about $20 to over $40 (pre-split) in a single month. Events like this make it very dangerous to short VXX.

In my newsletter, Terry's Tips, I have set up a portfolio I call Crash Control. It consists of VXX options which include many calendar spreads, a butterfly spread, and uncovered long calls. It is designed to make a small gain or at least break even if VXX falls a little each month (which it does most of the time) or goes up by any amount (which it does infrequently, but dramatically at times). The biggest risk in this portfolio is if it falls by more than 14% in six weeks, a downside adjustment would be necessary to prevent a loss from a further fall in the price of VXX. This adjustment would probably wipe out any gain for that month.

This portfolio should be compared to an insurance purchase. When you buy insurance, you really don't expect to cash in. You expect that your insurance dollars will be wasted, but you are covered in the event of a considerably greater loss if something really bad happens.

This portfolio is better than an insurance purchase in one important respect. I believe that in most time periods, it will actually make a small gain rather than costing you money. Here is the risk profile graph of the Crash Control portfolio at the close of trading on November 2nd:

This portfolio cost about $4300 to establish. The short options expire in six weeks, on December 21, 2012. At that time, if VXX stays flat, the graph indicates that the positions will gain $223, or about 5%. That is the lowest point on the entire graph (for any stock price above $30). The portfolio should make a gain at any VXX price above $30 (it currently trades at $35.25).

If the stock falls by 14% (to $30) during this time period the portfolio should make about 15%, but at that point you would need to protect yourself against a further drop, probably by buying another butterfly spread that would extend the downside protection another $3. This would likely wipe out any gain for that time period but would also make any loss a small one.

If VXX moves any higher in six weeks (which it would do if the market crashed or even if a minor correction took place), this portfolio could make considerably more. If VXX doubles in value like it did in the fall of 2011 when the European crisis was threatening, this portfolio would have also doubled in value.

In short, this portfolio is an excellent form of portfolio insurance, especially since most of the time, it could actually pay you back even if the calamity (a market crash) did not come about.

This portfolio has 10 custom butterfly spreads at the 33 - 30 - 27 strikes (the 33 strike is in Jan-13 puts while the other sides are in Dec-12 puts), 4 calendar spreads (Jan13 - Dec-12) at each of several strikes (36, 41, and 45), 2 similar calendars at the 33 strike, and 5 Jan-13 39 uncovered calls (these are what provide the big upside protection if the market crashes and VXX skyrockets).

Admittedly, this is a very complex set of option positions, but it is what I do every day. I use the Analyze Tab on the thinkorswim by TD Ameritrade software to figure out exactly which options need to be purchased to accomplish my objective of providing good crash protection and small gains if the market behaves in more moderate fashion.

It is important to understand that it is impossible to create an options portfolio that covers every eventuality, both for a higher or lower underlying price - I have spent thousands of hours trying to create such a portfolio over several decades and am absolutely convinced that the options market is sufficiently efficient to eliminate the possibility of such a portfolio. It is much like the impossibility of a perpetual motion machine - you just can't do it.

I believe that most months, the Crash Control portfolio will eke out a small gain while providing very strong protection against a market crash. It should make at least some gain if anything happens to VXX except that it falls more than 14% in six weeks. While historically, VXX has made major upside moves very quickly, downside moves have tended to be smaller and slower, except at times when VIX is unusually high, over 35, or about double what it is now.

I suspect (and hope) that most investors would rather buy a subscription to Terry's Tips and have the Crash Control portfolio carried out in their account through a broker's Auto-Trade program rather than doing it on their own. This article outlines how it can be done in case you are options savvy and like placing these trades on your own. I have not seen a better way to buy protection for your other investments against the next market crash that will surely come our way one of these days. If you know of a better way, please pass it on to me. I will be most grateful.

Disclosure: I am long VXX. 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: I am bottom-line long VXX through a portfolio of option spreads.