Note: This article was originally submitted mid-April, however while the numbers have changed, the suggestions made are just as relevant today as they were a month ago.
We are now in the heading into the 6th month of a major rally in US equities. I've discussed why I think this is the case and why it's likely to continue being the case in a series of articles published last year (Real-World Effects Of Treating A Country's Budget Like A Household Budget, The SPDR S&P 500 Option Yield Curve Turns Positive Signaling Long-Term Demand). However, investors are now starting to ask questions about the rallies sustainability. There are in fact good reasons to believe that we've gone too far too fast. If we were to continue rising at this pace the S&P500 would end the year approx. 35% up from the beginning of the year. I just don't think the fundamentals or sentiment support this.
Another reason to be worried is the fact that the rest of the world has not joined into this US rally. I do believe that the US still has the strongest and best diversified economy in the world but no country is an island. The austerity measures implemented thus far this year by the US government are also unexpected and troubling. The full effect of the increase in payroll taxes and sequestration spending cuts is yet to be felt and the impact is likely to be negative.
All this combined with the seasonality effect (September One Of The Best Months To Invest In The S&P500) appears to be creating the perfect storm environment for US stock market indices in Q2 and early Q3.
In the end though, for most long-term investors, the issue of a possible market correction is a minor one compared to the possibility of a full out reversal of trend. While personally I think the overall bull market has a long way to go there is no such thing as a sure thing in investing. I consciously keep in mind the small probability that this will be the third top of the new century before we head lower. However, while I admit the probability of this happening, I do not worry about it, because if it does, I will come out more than alright.
How is it possible to keep a long term bullish bias, capture virtually the entire upside of any rally, while at the same time profit from any market dislocations?
The key is efficient use of portfolio protection. The way I construct my portfolio I always have some absolute downside protection but in times like these a little extra insurance may be well worth your money.
I have recently purchased out-of-the-money put options on a couple of holdings in my portfolio that have done the best year-to-date (IBB, SPY). What may be surprising is that I did not purchase the exact amount of contracts to offset my exposure. The use of option contracts with their greeks, black-scholes model and implied volatilities can be really intimidating to most investors who are not used to them. Luckily, there is a simpler, more intuitive way to determine where to buy and it's called scenario analysis.
Choosing your time horizon
The first thing to consider is when you think the correction is most likely to take place. You would then choose the expiry date closest to but after you expect the move to complete. You could do all kinds of sensitivity analysis but the answer is always the same and intuitive. The best time period to buy is the one that matches your expected time horizon most closely. For example, if I believe that whatever correction takes place will likely complete by May 18th 2013 I would buy my contracts with that expiry date.
Sizing your bet
The second thing to consider is how much you can afford to spend on protection based on your portfolio size. The time horizon chosen above may be wrong, you may have to re-establish your protection at a later date, and you should make sure this does not destroy your overall portfolio performance. Also, if the market rallies you should still come out ahead at the end of the time period. I would suggest no more than 1% of your entire portfolio spent on insurance (preferably less).
Calculating the payoffs
The next thing to consider is how far the market would have to fall by the expiry date for the insurance to payoff and to offset any losses on your holdings. For example the following is a chart of possible payoffs for a $1000 bet in the case of a SPY drop of various magnitudes (including expected SPY prices for those drops) completing by May 18th 2013.
The last thing to do is to decide what the probabilities are for various magnitude drops for the security for which the insurance is being bought. There are many ways at arriving at those probabilities from looking at historical data to analyzing technical, fundamentals or even going with hunches. The choice can be as easy as choosing the most probable drop magnitude and choosing the largest payoff or as complicated as assigning different probabilities to different outcomes and multiplying the expected payoffs by those probabilities.
In the above screenshot I use the simple method of looking for the highest payoff for a given drop. In the case of an expected 5% drop completing by May 18th 2013 the SPY put option highlighted in blue with a strike price of 153 is the best choice. In the case of a 10% drop it would be the yellow highlighted option with a strike price of 149, while if the market collapses 15% the best choice will be the 141 strike highlighted in green.
What it all means
Lastly, you must consider what the dollar loss in your actual holdings would be given the simulated drops discussed above and compare that amount to the expected payoffs. Will the insurance payout fully cover your loss? And if not, is the coverage acceptable? Perhaps the payout will be larger than your expected loss in which case you will actually turn a profit.
In general it does not pay to protect against small loses because the insurance is too expensive. In addition when the market is already showing weakness and the implied volatility spikes it is generally too late to buy insurance at a reasonable price. The best time to buy insurance is when the market appears to have completed a large move and has been side-ways trending for a while. The S&P 500 today (Apr.18) is at the same level as it was on March 8th 2013. It seems to fit the bill and the protection is still relatively cheap.
This protection calculator can help you find the right option contracts to protect your investments.
Disclosure: I am long SPY, IBB. 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: In addition to my long positions I have purchased put options on both SPY and IBB that protect me from large losses