Yesterday, on CNBC’s online program Futures Now, Marc Faber, author of the Gloom Boom & Doom Report stated that he sees lots of similarities between the market in 2013 to the one that lead up to the 1987 Crash. Faber sees the possibility of the market closing the year down 20% from current levels. Watch here:
Full disclosure I have been a subscriber to Mr. Faber’s newsletter for years and I really enjoy his market insights. I appreciate Faber’s ability to make contrarian arguments with intelligent inputs that are not always that popular. A lot of people I know in the business dismiss guys like Faber and say “yeah yeah, if you are always calling for a crash and keep rolling out your time horizon, you will eventually be right” But that’s not the point. It’s not like the guy is always net short, and if you read his work, it is fairly obvious that he is always long risk assets, its just a matter of where and how. If you’re an investor, someone like Faber can be very helpful in waking you from a complacent slumber as you should always be re-examining your holdings. Thinking about a guy like Faber as The Boy Who Cried Wolf isn’t the right way to think about it.
This is what is great about options hedging. At times like this in the market where there is that small chance of Marc Faber being right, one doesn’t need to bail on their entire portfolio. Options allow for risk management in a way that the exhausting exercise by market timers of trying to “buy low and sell high” can’t.
Our View with the SPX up almost 19% ytd, and a little less than 1% from the all time high made last week is that if you have 20% gains or so ytd on long positions, it is a great time to start thinking about some sort of portfolio protection as we head into a seasonally volatile period (Sept.) All eyes will be turning to the FOMC’s Sept 17/18th meeting and the handicapping on the potential for the Fed to pull back a bit from their $85 billion a month bond buying pace will start in earnest quite soon. We are in the camp that a “Taper” is not “IN” the stock market up here and that the risk of a potential 10 to 20% plus draw-down vs. a 5% blow-off sort of top does not seem like an attractive risk/reward dynamic to own stocks here without hedging.
Our Strategy With the SPX just shy of 1700, we want to discuss ways to hedge an equity portfolio by using the SPY. Oftentimes long/short portfolio managers will use ETF shorts to hedge out net market exposure and just sell the difference btwn their longs and shorts to make their portfolio market neutral. There are lots of factors that make this a fairly inefficient hedge as it does not account for the beta of the lows, but we can leave that for another discussion. But the key point is that instead of shorting ETF’s against your longs, you would be better served 9 out of 10 times selling an out of the money call and using that premium to buy out of the money puts or put spreads. This strategy is called a collar or a put spread collar and allows you to participate on the upside (to a point) before your long exposure is greatly lessened, rather than immediately having any gains of the portfolio being lessened by the at-the-money ETF short. Obviously the big kicker is that a defined range of protection to the downside kicks in at a certain point, and hopefully you got this protection for little to no cost.
Trade Examples: Let’s assume we want to hedge a long portfolio of $100,000 worth of large cap U.S. stocks with the SPY at 169.20 looking at to the very end of the year using Dec31st quarterly options.
Hedge 1 – Protection back to the June lows:
SPY ($169) Sell Dec31 175 Call vs Buying Dec 31 165/154 Put Spread for even money
- Sell 5 Dec31 175 call at 2.50
- Buy 5 Dec31 165 Put for 5.00
- Sell 5 Dec31 154 Put for 2.50
Break-Even on Dec31st Quarterly expiration:
Where You Get Short: On expiration you will be short 500 shares SPY at 175, up ~3.5%, which is better in my mind than canceling out your potential gains immediately.
Where You Get Protection: Losses of stock portfolio down to about 165 in SPY, but have protection btwn 165 and 154, protection of almost of ~6.5% to down ~9% in the market from current levels. You have no further protection below 155.
Neutral: if the SPY is above 165 and below 175 both options expire worthless and you paid nothing for the protection
Trade Rationale: I chose a structure that costs me no premium and offers further upside potential, but gives me near the money protection (at the 50 day moving average) down to a level that should serve as the first level of a meaningful technical support, right below the June low and right at the 200 day moving average. Shaded area below shows hedged area.
I would add one important point, the strikes can be moved around to offer different levels of protection with the trade off of potential upside and how much premium you want to spend. Generally when we outline these sorts of trades we do so with the idea of paying nothing or getting a credit.
Hedge 2 – Crash Protection Below the January Low
SPY ($169) Sell Dec31 175 Call and Buying Dec 31 155 Put for even money
- Sell 5 Dec31 175 calls at 2.50
- Buy 5 Dec31 155 puts for 2.50
Break-Even on Dec31 expiration:
Where You Get Short: On expiration you will be short 500 shares SPY at 175, up ~3.5%, which is better in my mind than canceling out gains immediately.
Where You Get Protection: Losses of stock portfolio down to about 155 in SPY, but have protection below 155 , this is crash protection, you are giving up a portion of future gains to sleep well at night that if Faber is right, you will not get wiped out.
Neutral: if the SPY is above 155 and below 175 both options expire worthless and you paid nothing for the protection
Trade Rationale: You are less concerned with the next 10% and more concerned of a flash crash, a protracted sell off like the second half of 2008 or a possible 1987 style crash. Chart below shows the level below support since March and the 200 day moving average where protection kicks in.