Help, who shrunk my portfolio?!

by | Dec 21, 2018 | Bishop's Corner

How bad are things out there?

I was reading Jason’s email this morning, and he mentioned that this is the worst start for stocks since 1931. If conditions don’t improve this will be the worst year since 2008.

But that’s not all…

Last night Jim Cramer recommended to his viewers that they buy gold. But can you blame him? This is a scary time for long-term investors, especially for one’s approaching retirement.

That said, there are steps you can take to help stop the bleeding if you’re in a bad position. Personally, I think these steps are better than “waiting it out” or “panic selling.”

The best way to build wealth in the market is through active investing, I’ve made a fortune doing it and have taught others as well. If you’re interested to find out more about active investing and how to make money when stocks are crashing, check this out.

Protecting Your Portfolio

Let’s face it…people make money with long-term trading, but there’s also more risk with this style of trading, especially when you get close to retirement age.

You see, long-term traders are tied to their positions for multiple months – even years sometimes. When we were in one of the most historic bull markets, it made everyone look like a freakin’ genius.

However, stocks go up and down. And now they are going down a lot more than they are going up. So much so… we are in bear market territory.

Many of those long-term longs have wiped away 3-5 years worth of gains in less than 2 months. Some are even down a considerable amount.

You can “wait it out” and “hope for the best” …. But if you want to take a more active approach here is how to do it – hedging.

Now, when you hedge your portfolio, think about it as an insurance policy. You’re paying a premium to protect your portfolio from the risk of adverse price movements. More specifically, you’re offsetting your long positions to reduce your risk. Heck, sometimes, you can make more money on your hedge than your initial position.

For example, let’s assume you’re long the SPDR S&P 500 ETF (SPY) – an exchange-traded fund (ETF) tracking the S&P 500 Index – but are worried about a selloff…hedging comes into play here.

You’re probably wondering, “This all sounds great Jeff, but how exactly do I hedge my portfolio?”

Well, you can either:

  • Buy put options.
  • Buy inversely-correlated products.
  • Buy a basket of options to play for an extreme move.

Put Options as a Hedge

You can buy put options and put spreads to hedge nearly any security, whether it be a stock or an ETF.

For example, let’s assume you’re long 100 shares of Apple Inc. (AAPL) at $158 and holding it for the long term. However, with the recent market volatility, you think AAPL could fall in the short-term before it runs higher.

Here’s a look at the risk profile – or profit and loss (PnL) chart – of that position:

Notice how it’s just a straight line, if AAPL falls by $1 from your entry, you would be down $100 unrealized.

But how can you change this risk profile to protect your downside?

Well, if you buy a put option on AAPL, it floors your downside.

Here’s a look at the risk profile for the $150 puts, expiring three months.

Notice how when the stock drops below the strike price less your cost, the PnL for the put option position starts to generate profits.

Well, here’s what buying a put option on a long position does:

Notice how your downside is capped here. The most you could lose is $1,640…but your upside potential is theoretically unlimited because you don’t know how far a stock could move higher.

This is often thought of as the simplest way to hedge your positions.

Now, what happens if you’re long a bunch of stocks? You can buy put options on an ETF tracking the market or a specific sector.

Put Spreads to Hedge

Keep in mind, volatility plays a key role when you’re buying options. Since implied volatility is factored into the pricing of options, you can reduce your hedging costs with spreads.

More specifically, you can buy put spreads if implied volatility is high.

Take a look at the PnL chart of a bear put spread:

When you’re hedging, it helps to understand current market conditions and volatility levels if you want to use options…but what if you don’t have access to options trading yet?

Well, there are other ways to hedge your portfolio.

Buying Inversely Correlated Products as a Hedge

Now, there are some products that are inversely correlated to stocks. Precious metals and bonds come to mind as a hedge for a long-term stock portfolio.

You see, precious metals and bonds are thought of as flights to safety. In other words, when the market is selling off, precious metals and bonds tend to rise. When one security goes up, while another goes down in lock step…it means they are inversely correlated to each other.

That said, if the market is in correction and bear market territory, precious metals and bond ETFs could serve as a hedge. Basically, you’re looking for these assets to be bid up due to an increase in market volatility.

There’s another way to hedge your portfolio…

Tail Hedging

There are funds out there that play for tail events – also known as “black swan” events. Contrary to what many traders say, tail events occur more often than you’d think. Heck, one so-called “black swan” made $1B in one day in 2015.

Now, a black swan event is hard-to-predict, extremely rare, and goes beyond the reservations of normal expectations. Tail events are outliers, carry an extreme impact, and makes many traders concoct explanations for its occurrence.

However, it’s nearly impossible to explain how and why these events occurred until after the fact.

Your portfolio doesn’t care about the explanation…sometimes, you just have to be positioned for the event.

Think about this…normally, the markets returns are clustered, not moving too much – you’ll notice it tends to be up or down anywhere between 0.25% and 1%. It’s extremely rare to see moves greater than 5% in market ETFs.

Now, we won’t get into the mathematics of statistics and probability. But I’ll give you a simple explanation…

When tail events occur, all the action is in extreme price movements. That means there won’t be as many small moves. Basically, with tail events, you tend to see multiple days with large moves, but there are fewer days where the market move up or down a quarter of a percent.

But how can you play for an extreme move using this evidence?

Well, there is one options strategy that comes to mind…

Basically, the way the math works out, you want to be short an at-the-money (ATM) straddle, and buy a ratio of deep-out-of-the-money (OTM) calls and puts.

Here’s a look at the risk profile of this strategy:

Now, SPY was trading at $247 at this time…if you were looking for a tail event to happen, you would sell the $247 straddle expiring in X months and buy multiple OTM calls and puts. Notice how this strategy sold 2 ATM straddles and bought 20 deep OTM calls and puts. This is a ratio of 10 (selling 2 ATM straddles and buying 10 times as many deep OTM calls and puts). Keep in mind, you can use any ratio you see fit, but generally, you would want to buy 3 times as many OTM calls and puts than straddles.

Pretty simple right? If there’s an extreme move in either direction, you’re banking.

If this all sounds exotic to you, check out this options guide.

What if you were extremely bearish and believe a Black Swan event could cause the market to sell off? Well, you could do the same strategy, but just not buy the deep OTM calls.

Here’s how that risk profile would look:

So if you are long SPY, the PowerShares QQQ Trust (QQQ), or iShares Russell 2000 Index (IWM), and believe the market could enter correction or bear market territory…you might want to pull this out of your trading arsenal.

In my opinion, the best defense is offense.

That said, I know a lot of folks feel trapped right now and I just want to provide some ideas that could help. Make no mistake about it, 2019 is going to be an exciting and volatile year. I look forward to trading these markets with you.

To YOUR success!

Jeff Bishop

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