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A Cheap Hedge for This Market | The Mesh Report

A Cheap Hedge for This Market

John Thomas January 23, 2018 Comments Off on A Cheap Hedge for This Market

The S&P 500 is now 5.66% above its 50-day moving average, the biggest gap in history, which itself is rising sharply.

So financial advisors, pension fund managers, and cautious individuals have been ringing me up asking what is the best way to hedge already heady 2018 gains.

You can forget about buying the Volatility Index (VIX), (VXX). The huge contango, the discount front month futures contracts have to far month ones, almost guarantees that your hedge will be enormously expensive and expire worthless before it has the chance to do any good.

If you don’t believe me, check out the chart for the Velocity Shares Daily Inverse Short VIX ETN (XIV), which has gone ballistic since the last election, from $12 to $146, and is a bet on falling volatility.

No, there’s a much better way to do this

Buy deep out-of-the-money, long dated S&P 500 (SPY) put options. You want to go deep out-of-the-money so your insurance policy is cheap.

You also want to go long dated, so time decay doesn’t kill you and your option position lives long enough to do some good. By long dated I’m thinking five months out, like the June 15 2018 option expiration date.

All of this logic points to the (SPY) June 2018 $250 puts today priced at $2.50, which as of today are 10% out-of-the-money.

Here is the beauty of this position. A put option rises in value in falling markets. But so does option implied volatility, creating a leveraged hickey stick effect on the value of your put position. And deep out-of-the-money options always see implied volatilities rise much faster than near money ones.

You don’t need the market to drop the full 10% to make enough profit on this position to offset losses elsewhere in your portfolio.

A much more likely 5% market correction would cause the value of the June 2018 $250 puts to jump from $2.50 to $4.10, a gain of 64%, as long as that drop happens soon. However, add in an expected pop in implied options volatility and the profit could be as much as 100%.

So how many June 2018 $250 puts should you buy?

Let’s say you have a $100,000 portfolio. Only four put option contracts would provide enough coverage for your entire exposure ($100,000/100 shares per contract/$250 (SPY) strike price) = 4 contracts rounded off. Four contracts of the June 2018 $250 puts will cost you $1,000 (4 X 100 shares per contracts X $2.50).

In other words, $1,000 buys you an insurance policy on $100,000 portfolio exposure for five months. Sounds like a deal to me.

There are a few qualifications with such a simple hedge. Let’s say that you read the Diary of a Mad Hedge Fund Trader and have a highly concentrated portfolio focused on technology, energy, financial, commodities, and industrials.

It such a case the tracking error between the (SPY) and your portfolio will be large (after all, that is the point), and you may not get all the downside protection you want.

On the other hand, what if we really get the 10% correction? What if the black swans suddenly land in flocks? In that case the value of your June 2018 $250 puts soars to at least $8.25, and more likely $12 when you add in the expected effects of rocketing implied volatilities. The value of your hedge rises to $4,800.

Yes, you don’t get complete 1:1 coverage. But it’s better than going into such a route naked, with no downside protection at all.

Let’s say you’re a cheapskate and you want your insurance policy for free. Yes, this can be done.

In addition to buying your June 2018 $250 puts, you also sell short an equal number of June 2018 $295 call options, which are 5% out-of-the- money. This gets you $740 in cash ($1.85 option cost X 100 X 4 contracts) which you can use to offset the cost of your June 2018 $250 puts.

The net cost of the five-month hedge then drops to only $260 ($1,000 – $740 = $260). This is what the pros do.

This kind of long put short covered call strategy is called a Collar, and is a classic risk control position used by big hedge funds.

Of course there is the risk that the market rises by more than 5% and your short call options get exercised against you. But if that happens you’ll probably be too busy dancing in the street to notice, as your entire portfolio has just risen sharply in value.

There is another hedging strategy that is far easier to execute. Just take a long cruise around the world. That way, corrections will come and go and you might not even know about it, unless your butler brings you a copy of the Wall Street Journal every morning, as mine does.

This is the hedging strategy most of you have pursued for the past nine years and it has worked really well. At least you end up with a nice tan and some pleasant photos.

As for the June 2018 $250 puts they’re most likely end up expiring worthless, but you’ll sleep better at night. Such is the price of peace.


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