Thu Nov 06 2014
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Protect Yourself Against a Market Downturn


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October has passed with only a modest market blip, and the S&P 500 is once again above the 2,000 mark.

That means it’s more difficult than ever to generate a decent dividend income out of stock holdings, where price risk is significant.

Income investors, therefore, must work hard to protect themselves against a price downturn – both to avoid losses and also to provide sources of new cash that can be invested when stocks are cheap and dividend yields are high.

In times when the market is high, my favorite recommendation is to take an insurance approach. Here are two ways to protect yourself today…

A Few TIPS

While a “buy and hold” investment strategy has worked well for the last 30 years, its risk-reward ratio is getting steadily worse.

If you deploy new money into an S&P 500 index yielding only 2%, you’re receiving an inadequate income and risking losses that can’t be quickly recovered.

Meanwhile, moving into cash protects you against the downturn but gives you almost no income (at the moment). If you’re seeking to fund a retirement from savings, that’s no use – it merely depletes your savings. Plus, you’d need a direct line to the Almighty to know when to switch into and out of cash; mere mortals are only too likely to get whipsawed.

Therefore, I recommend devoting no more than 2% of your stock portfolio to buying instruments that are highly leveraged, which will allow you to benefit when the market tanks.

That way, the hedging investments will come good just as everything else is failing, providing you with extra cash at the bottom. You can then use this cash to invest in the stock bargains that will have appeared.

For starters, I recommend Treasury Inflation Protected Securities, probably through a fund such as the Vanguard Inflation-Protected Securities Fund (VIPSX). That would give you a yield of 1.7%, almost all of which represents the return from inflation protection.

In my view, though, the best hedging investment is out-of-the-money puts on the S&P 500 Index, which are traded on the Chicago Board Options Exchange (prices available under the SPX symbol on their website).

Put Up or Shut Up

For example, when the Index is trading just above 2,000, the December 2016 puts with a 1,200 strike price (SPXX16162120000) are offered at $ 29.50. (Of course, you can buy puts with a different strike price. In practice, I like to buy puts selling in the $ 25 to $ 30 range, which seem to offer the best risk-reward characteristic.)

Thus, for $ 2,950 – or, in practice, probably a little less, as most deals are done within the official quoted spread – you can buy one contract that entitles you to put the option seller 100 units of the S&P 500 Index for a total of $ 120,000 at any time until December 17, 2016. In practice, the options are cash settled, and it’s wise to either sell them or let them expire to avoid administrative complications.

A 1,200 strike price sounds like a big drop from 2,000 (it’s 40%), but the purpose of these put options is not to correct for every little blip. Instead, they’re meant to make money from a major bear market and compensate you for the losses on your stock portfolio.

As you’ll see from the CBOE’s price table, 2016 options that are “at the money” trade for around $ 200, so if stock prices were to drop rapidly to S&P 1200, you’d make a 700% to 800% return on your options.

That being said, there are two important factors to consider when buying long-dated put options – one that helps you and one that hurts you.

First, the bad news: As the options move towards expiry, their price will decline. Thus, the December 2015 1,200 option is much cheaper than the 2016, at around $ 11. On the other hand, at-the-money options lose less of their value. The December 2015 2,000 put is currently around $ 150, compared with $ 222 for the December 2016. The 2017 puts will appear in December, and you can get an even longer run of protection by buying them.

The more helpful factor is that put prices depend on the implied volatility of the index. The volatility used for options pricing, known as the Volatility Index (VIX), acts as a “fear factor,” and tends to zoom up when the market declines sharply. That, in turn, raises the price of the options. If the market falls out of bed, therefore, you can gain back on the volatility rise what you lose on the time lapse of your put options.

Bottom line: There are no perfect ways of hedging against a market decline… but long-dated S&P 500 puts get quite close.

Good investing,

Martin Hutchinson


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