In this weekend’s Barron’s Striking Price column, long time columnist Steve Sears, (who I am a big fan of) had Steve Sosnick of Timber Hill fill in to discuss hedging ones portfolio into the Nov 8th election (A Guide to Hedging Election Outcomes). The question Sosnick was asked by a friend regarding portfolio protection is one we get often from readers. Sosnick’s friend would like to protect against a possible 10% drop if Trump were to shock betting markets and win. Although it seems unlikely at this point, a month and half before Brexit the same could be said. Sosnick detailed the following strategy in the SPY:
Our conversation focused on SPY 200 strike puts expiring on Nov. 18, 2016. Although there is now an expiration date closer to the election, the extra week could prove beneficial if the election results prove to be uncertain. The strike is somewhat less than my friend’s anticipated 10% move, but trying to match your strike too precisely runs the risk of the option being just out of the money at expiration, even if you predict correctly.
The market seems to be pricing in very little election chaos. The implied volatility of the 200 puts that expire on Nov. 18 was recently about 19. That compares to about 18.5 for the same strike puts that expire on Nov. 4, the Friday before the election. Each contract purchased for roughly $1 could potentially protect as much as $20,000 of equity exposure. If investors expect even a 5% chance of a truly unfavorable outcome, the trade could become profitable.
This discussion is one that should be had by all investors in front of potentially volatile events. Deciding what the odds are of unforseen event, how the market may react and whether that uncertainty is worth the money spent to hedge. Most of the time it is not. But in certain instances, for example for a nervous investor near an all time high hedging can be the difference that allows for long term investing versus being scared into frequent early profit taking.
No back to the trade. It’s important to note that while the vol differential between the two weeks in the way out of the money puts is immaterial, that doesn’t mean the options market makers are off sides. The Nov 18th 200 puts have about a 12 delta. That means the options market is placing a 12% chance that those puts would be in the money. Basically a lotto ticket. I don’t know about you, but I’d prefer spending that premium in a different capacity (nearer to the money in smaller size, or in a put spread) to serve my interests better than buying what may equate to a lottery ticket. The reason for that is that a couple scenarios could result in a a market sell-off. The first is the one detailed above. But the other is a more run of the mill sell-off even if Clinton wins. The reason for that may be that some sort of consistent polling over the next few weeks allows the market gets ahead of itself, and then you see a sell the news type reversal after the election (or even before).
On Friday I highlighted a similar point (SPY – Back in the Straddle), about the cheapness of short dated SPY options. In this case I used Oct expiration as it would catch the next presidential debate on Oct 9th, possibly some sort of resolution or meltdown of Deutsche Bank (DB) and the start of earnings season, all events that added to market volatility this past week. But if you were inclined to extend this view to catch the election in early Nov then buying a put spread nearer the money may serve you better as it’s not just inthe case of some sort of election shock.
For instance, if you were looking to protect against a 10% decline in the next 6 weeks you might consider the following trade against a basket of large cap U.S. stocks with the SPY at $216.3:
SPY Buy Nov 210 / 195 put spread for $1.70
- Buy 1 Nov 210 put for 2.35
- Sell 1 Nov 195 put at 65 cents
Break-Even on Nov expiration:
Profits/Protection: between 208.30 and 195 of up to $13.30 with max gain/protection at $195, with none below there.
Losses: up to $1.70 between 208.30 and 210, max loss above 210
Rationale: While this protection costs 70 cents more than the hedge detailed in Barron’s, the Nov 210 put has a far greater probability of being in the money than the 200 put and the sale of the 195 is unlikely to be tested.
$211 appears to be a support level that needs to hold near term, as there is little support below to about $200. For the example I used above I chose the breakdown level at $210 and the the short strike at $195, down about 10% to help lessen the premium outlay. It would have to be total Armageddon for the SPX to be below 1950 in my opinion by Nov expiration.[caption id="attachment_66796" align="aligncenter" width="600"] SPY since Aug 2015 from Bloomberg[/caption]
There are a few ways to skin a cat. Sosnick’s example is perfectly valid, but it is simple protection for a market meltdown. For those looking to protect against a more run of the mill pullback that would also help in the case of a meltdown, a closer to the money spread may make sense.
In both cases the hedge should be money that you wouldn’t mind losing on a market breakout. And that’s where the hedges are valuable, because they can often be just the thing that keeps you there for that breakout.