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Risk-Off Using Put Options As 'Insurance' In These Frothy Markets

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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: Cameron Smith
Cameron Smith
Value, contrarian, long-term horizon, growth at reasonable price
Summary

With markets at record highs and volatility cheap, it looks like a great time to lock in some of this year's gains.

Using a protective put allows an investor to continue participating in the upside of the market while limiting the downside.

Staying invested in the market and collecting dividends offsets part of the options cost.

By hedging away the market risk or beta in the portfolio, investors can continue to focus on "seeking alpha".

With the market at record highs it is time for value investors to start thinking about taking some market risk off the table. Value investors might already be sitting on a pile of cash similar to the recently reported $128 billion cash pile at Warren Buffett's Berkshire Hathaway (BRK.B)... similar relative to the size of one's portfolio that is... and normally in times of market froth such as today, I have slowly moved into cash and equivalents. But this selling comes with drawbacks such as capital gains taxes, transaction costs, and the possibility of missing out on further market gains. This time around, I will be looking at partially incorporating a protective put option strategy to reduce my portfolio's risk at these levels and to also try and avoid some of the pitfalls with going to cash.

Chart
Data by YCharts

Markets are Expensive

A lot of the ways I look at it, market levels look expensive. Not only is the S&P 500 around 31.5% higher than its low of 2,347 hit late last year, but market valuations also look frothy. Some of the most popular metrics for evaluating the market are all well above their historical averages such as the Shiller CAPE and Tobin Q ratio. Let's take a look at the current levels of these two metrics below.

Shiller CAPE - Currently at 30.4x P/E which is well above its historic average of 16.7x. This metric attempts to average out earnings over the business cycle by looking at the inflation-adjusted earnings from the previous 10 years. CAPE stands for Cyclically Adjusted Price-to-Earnings.

Sourced from multpl.com

Tobin Q - The Tobin Q ratio is currently near all time highs of 1.85x which is much higher than its average of just under 0.8x. Theoretically, if greater than 1, or the long-term average, the market is over-valued and will revert to the mean or the replacement cost of assets. The Tobin Q ratio measures the enterprise value (debt + equity) of the market divided by the replacement cost of the assets in the economy. It be calculated from data published in the Flow of Funds Accounts of the United States-Z.1 The Fed - Financial Accounts of the United States - Z.1 - Release Dates.

Sourced from Advisor Perspectives

What is a Protective Put?

A Protective Put is a bearish options strategy that involves continuing to hold the underlying stock or asset while also purchasing a put option for an upfront premium which gives the investor the right to sell the underlying asset at the strike price. The investor stays long the underlying asset and can continue to participate in its fair value gains and dividends but is limited to the downside by the strike price on the put option. The upfront premium the investor pays for the put option can be expensive but the dividends the investor still receives from being long the underlying asset can help to offset some of this cost. Because of the protective puts limit on the downside, the strategy is often thought of as buying insurance on the owned asset.

Volatility is Cheap

Volatility is arguably the most important factor that gets built into the price of an option (that premium talked about earlier). The great news is that rising markets like we are experiencing now are often accompanied by calm in the markets which seems to be what is happening. Below is a graph showing the declining CBOE S&P 500 Volatility Index (a.k.a. the VIX) over the past few weeks to sit near 52-week lows.

Chart
Data by YCharts

Focus on the "Net" Cost of Insurance

It is important to focus on the "net" cost of the protective put option strategy. In my situation of purchasing a put option on a major market index, such as the S&P 500, to insure my portfolio against broad market declines I will be paying the put option premium but will continue to receive the approximate 3.5% weighted average dividend yield of my portfolio.

While I have looked into put options on some of the most popular S&P 500 ETFs such as (VOO) and (SPY), the cheapest premiums I could find on put options for the S&P 500 were the CBOE's Mini S&P 500 Index Options (XSP). Looking to purchase insurance for one year, I was drawn to the September 2020 put options which currently cost a premium of around 5.5% for an at-the-money put option. This means that the net cost per $1 value to hedge away the market risk/beta of my portfolio while I stay invested and collect dividends is only approximately 2.0% (5.5% put option premium - 3.5% portfolio weighted average dividend yield).

Hedge Away the Market Beta and Focus on Alpha

Market valuations look expensive and the protective put option strategy is an intriguing way to take some market risk off the table without incurring what can be significant capital gains taxes, transaction costs, and potentially missing out on further market gains. With market risk/beta partially insured out of the portfolio, investors can continue to focus on seeking alpha.

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Additional disclosure: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience, and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.

Disclosure: I am/we are short XSP. 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 long put options on the CBOE Mini S&P 500 Index at a $304 strike price.