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Cheapest Method To Hedge


AccentricInv
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I feel like the market may be on its last legs, and suspect that we don't have much time left in this 7 year bull market (IMHO).  There's just too many issues around the world, combined with relatively expensive US valuations for me to feel comfortable.

 

As such, given this situation, my question is how is everyone else hedging their portfolios in this market?  What do you think are the cheapest ways to hedge a portfolio (6mo / 12mo S&P Put vs. individual shorts vs. shorting some sort of FICC instrument)?  The 6mo S&P put at the moment is going to cost 5% to break-even, which seems a little expensive... Any creative ideas out there?  Or is this the best option?

 

Thanks in advance!

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I suggested something crazy two or three years ago which I think now is bang on.

 

If you find no bargains or companies with more upside (much more to ensure a margin of safety) than the market, then you should hold cash.

 

Then your hedge, should be S&P calls. Not puts but, calls.

 

This would have worked beautifully and I still think it works.

 

The reason is that the S&P tends to go up overtime, not down. Think about Buffett and the continued increase in GDP and standard of living. So puts are a money loser game unless your timing is perfect. Moreover, if the S&P goes down, you will never know when to cash in: you will have no yardstick, no bell ringing, just trying to get a feel for the maximum panic from the crowd.

 

So IMO cash is the best hedge if you can't find bargains. That is a lot of risk on its own to sit out the market because you can't find good investments. So if they come, dry powder is there sitting anyway. Then, if the market keeps going up, the calls will give you the upside at a very low cost since they have likely been bought with very low volatility.

 

Cardboard

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Historically moving to a permanent portfolio asset allocation (25%cash,25%gold,25%LTT,25%stocks) in these times would have been a very good idea.

Personally i hedge with futures (I favor Russell2k, DAX and FTSE futures at the moment for that) over the summer, because that has worked for me very well and the carry cost is minimal. But i have at least a small edge in market timing. (>60% batting average)

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I like cardboard's idea. If I was the cash holding or hedging type I'd seriously consider.

 

Agreed, its brilliant.  If you must hedge.  I have been greater than 100% invested for nearly 20 years.

 

Me too, always +100% invested. There's always a load of stuff better than cash. And for most of the last 15 years there hasn't been much, if any, competition from rates or bonds.

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Also, what about adding short puts into the mix. If one doesn't want to be a net buyer of optionality. short some puts and use premium for calls. Obviously sizing important as the whole point of the cash I would imagine is to have it there to spend in a decline. And not to have to spend it all when put to.

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Also, what about adding short puts into the mix. If one doesn't want to be a net buyer of optionality. short some puts and use premium for calls. Obviously sizing important as the whole point of the cash I would imagine is to have it there to spend in a decline. And not to have to spend it all when put to.

 

…and, tadaa, you're long again!  ::)

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I suggested something crazy two or three years ago which I think now is bang on.

 

If you find no bargains or companies with more upside (much more to ensure a margin of safety) than the market, then you should hold cash.

 

Then your hedge, should be S&P calls. Not puts but, calls.

 

This would have worked beautifully and I still think it works.

 

The reason is that the S&P tends to go up overtime, not down. Think about Buffett and the continued increase in GDP and standard of living. So puts are a money loser game unless your timing is perfect. Moreover, if the S&P goes down, you will never know when to cash in: you will have no yardstick, no bell ringing, just trying to get a feel for the maximum panic from the crowd.

 

So IMO cash is the best hedge if you can't find bargains. That is a lot of risk on its own to sit out the market because you can't find good investments. So if they come, dry powder is there sitting anyway. Then, if the market keeps going up, the calls will give you the upside at a very low cost since they have likely been bought with very low volatility.

 

Cardboard

 

There shouldn't be a difference between owning a call + cash vs. owning equities + put. It's the same trade (unlimited upside + downside limited at the strike price).

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The most efficient way to hedge market risk without selling your stocks is the futures market. With options, you're always taking a stance on future volatility (expectations) and timeframe for a potential decline — which can be just what you want, just be aware of it.

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You guys are right, I love the optionality of cash and the dry powder aspect.  I'm currently in 30% cash for that reason, and have been raising it steadily since.  However what I'm concerned about is the 70% exposure that I do have.  These are names that I feel are high quality, defensive names that would decline less in a downturn.  However they would still decline in a broad sell-off, and I'd rather not trim the exposure (including not taking a short-term tax impact).

 

Cardboard, that's a very interesting idea that I've never thought of.  Vol is pretty cheap these days, so I think that'd be a very interesting strategy.

 

Ni-Co, I need to explore the futures route a bit more.  That seems promising as well.

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Also, what about adding short puts into the mix. If one doesn't want to be a net buyer of optionality. short some puts and use premium for calls. Obviously sizing important as the whole point of the cash I would imagine is to have it there to spend in a decline. And not to have to spend it all when put to.

 

…and, tadaa, you're long again!  ::)

 

Obviously.  But we were discussing a hedging but with some length. To guard against what has been significant upward bias over the years. The money spent on the calls are also "length"  that is lost in the event of a decline just like the net of the put premium received,  the value of the underlying and the strike.

 

The value to considering some combination of the two is that one is not always long optionality/volatility but also a seller.

 

Clearly, given the goals and opinions of the bearish market timer who started the post, both the call buying and or the put selling would be small. But the general upward bias is a historical fact, as is the dubious record of macro market timing theses, so cardboards idea probably deserves consideration even for the bear.

 

 

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"There shouldn't be a difference between owning a call + cash vs. owning equities + put. It's the same trade (unlimited upside + downside limited at the strike price). "

 

In theory yes, in practice absolutely not!

 

The reason is correlation. If you buy puts against your specific stocks then yes, it would work. However, and I have been burned by this before, do not assume that your stocks will behave the same way as the general market.

 

Last year is actually a great example of that with a majority of stocks entering into bear market territory or over 20% declines while the S&P is pretty much flat. Hedging using S&P puts would have been a disaster: losses in your portfolio + premium losses on the puts.

 

Cardboard

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"You guys are right, I love the optionality of cash and the dry powder aspect.  I'm currently in 30% cash for that reason, and have been raising it steadily since.  However what I'm concerned about is the 70% exposure that I do have.  These are names that I feel are high quality, defensive names that would decline less in a downturn.  However they would still decline in a broad sell-off, and I'd rather not trim the exposure (including not taking a short-term tax impact)."

 

I assume that these are stocks that you have held for a while and have unrealized capital gains and are not very cheap but, not at your selling price yet.

 

If that is correct, then one strategy that I find interesting is to buy slightly out of the money puts on these names with a 5 to 6 month duration to protect your downside and to finance the puts with the sale of out of the money covered calls of the same duration.

 

So in essence, this strategy does not cost anything. It will protect your downside against a material slide in the market and if your stocks go up to the level of the covered calls, that would likely represent a good sale anyway.

 

Cardboard

 

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I suggested something crazy two or three years ago which I think now is bang on.

 

If you find no bargains or companies with more upside (much more to ensure a margin of safety) than the market, then you should hold cash.

 

Then your hedge, should be S&P calls. Not puts but, calls.

 

This would have worked beautifully and I still think it works.

 

The reason is that the S&P tends to go up overtime, not down. Think about Buffett and the continued increase in GDP and standard of living. So puts are a money loser game unless your timing is perfect. Moreover, if the S&P goes down, you will never know when to cash in: you will have no yardstick, no bell ringing, just trying to get a feel for the maximum panic from the crowd.

 

So IMO cash is the best hedge if you can't find bargains. That is a lot of risk on its own to sit out the market because you can't find good investments. So if they come, dry powder is there sitting anyway. Then, if the market keeps going up, the calls will give you the upside at a very low cost since they have likely been bought with very low volatility.

 

Cardboard

 

There shouldn't be a difference between owning a call + cash vs. owning equities + put. It's the same trade (unlimited upside + downside limited at the strike price).

 

in theory they are the same, in practice, people have the tendency to become complacent and sell out of the put at the exact wrong time, then holding onto equities due to sunken cost, so call + cash is probably better if you are not a disciplined/somewhat good trader

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"You guys are right, I love the optionality of cash and the dry powder aspect.  I'm currently in 30% cash for that reason, and have been raising it steadily since.  However what I'm concerned about is the 70% exposure that I do have.  These are names that I feel are high quality, defensive names that would decline less in a downturn.  However they would still decline in a broad sell-off, and I'd rather not trim the exposure (including not taking a short-term tax impact)."

 

I assume that these are stocks that you have held for a while and have unrealized capital gains and are not very cheap but, not at your selling price yet.

 

If that is correct, then one strategy that I find interesting is to buy slightly out of the money puts on these names with a 5 to 6 month duration to protect your downside and to finance the puts with the sale of out of the money covered calls of the same duration.

 

So in essence, this strategy does not cost anything. It will protect your downside against a material slide in the market and if your stocks go up to the level of the covered calls, that would likely represent a good sale anyway.

 

Cardboard

 

+1.  The problem with futures is you can't buy futures on specific stocks.  OTOH, Cardboard's strategy is nearly a sale in the sense that you've limited both your upside and your downside for the stocks you hold to avoid the tax liability.  The other nice thing is that volatility is up quite a bit recently, but you'd offset the cost with this strategy.

 

I like that far more than the buy calls/ sell puts strategy, which could work out even worse than an unhedged portfolio particularly if you get caught in a seller's market for insurance.

 

If you were 100% cash, I would say just stay that way.  You are somewhat bearish but don't take a strong view on the magnitude or the timing.  My personal bias is that every trade you make should be thought of as a directional bet (caveat: I consider multi option strategies with the same underlying as single trades here).  In other words, hedging a portfolio by selling S&Ps is really making 2 directional bets ("one" on your stocks and one on the S&P).  Corollary - the less sure you are of the future direction of the securities you hold, the closer you should move toward a liquidation structure, as Cardboard provides.

 

Caveat 1: if you have strong views, the best portfolio will nearly always be fully invested, long or short or both.

 

Caveat 2: if you are not a good options trader, you had better start reading, or you are likely to surprise yourself with any of the above-mentioned scenarios.

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An author I follow on SA has been talking about hedging his positions by 30% for the last year or two. Instead of buying puts on the SPY, he buys them for specific companies that have tight margins, are over valued and have performed poorly in recent recessions, all at a cost below 3%. Hes actually had the insurance for free for the last two years and the proceeds have paid for his 2016 insurance.

 

http://seekingalpha.com/article/2177103-the-time-to-hedge-is-now-do-it-for-less-part-i?source=author_profile_page

 

He spreads the puts out among the weakest companies in the industries in which his holdings are operating.

 

Interested to hear what you guys make of this strategy?

 

Phil

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  • 3 weeks later...

An author I follow on SA has been talking about hedging his positions by 30% for the last year or two. Instead of buying puts on the SPY, he buys them for specific companies that have tight margins, are over valued and have performed poorly in recent recessions, all at a cost below 3%. Hes actually had the insurance for free for the last two years and the proceeds have paid for his 2016 insurance.

 

http://seekingalpha.com/article/2177103-the-time-to-hedge-is-now-do-it-for-less-part-i?source=author_profile_page

 

He spreads the puts out among the weakest companies in the industries in which his holdings are operating.

 

Interested to hear what you guys make of this strategy?

 

Phil

 

Thanks for the link Phil.  I read through few of his articles.  It is a very viable strategy, and as he says relatively cheap.  Basically he picks companies that are heavily leveraged in some way to the economy, and buys way out of the money puts.  He allows them to expire worthless, unless there is a significant market pullback.  He spreads them across industries.  The bulk of his 'normal' portfolio is in dividend growers, which he mostly leaves on autopilot unless they become way overvalued, and it seems unsustainable. 

 

So, recently he has shorted (via puts) capital one financial (cof) the premise here is that in a recession/pullback credit defaults in cards will rise.  The stock always tanks with the general market.

Ual - United Airlines parent - heavily leveraged to all sorts of good economic news - very vulnerable in a downturn - It is near cyclical highs and always crashes with the markets.  Why anyone would ever buy this company is beyond me. 

Gt - goodyear tire and rubber - leveraged to the auto industry

Maasco - levered to home sales and home repairs

marriot hotels - levered to a healthy economy

Generally all the companies he has picked also have greater than industry financial leverage as well. 

He has several more suggestions. 

 

I have been looking for ideas to protect my assets without going to cash, and am exploring this. 

 

In the past I have tried index puts, with little success - they tend to be expensive and decay quickly. 

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An author I follow on SA has been talking about hedging his positions by 30% for the last year or two. Instead of buying puts on the SPY, he buys them for specific companies that have tight margins, are over valued and have performed poorly in recent recessions, all at a cost below 3%. Hes actually had the insurance for free for the last two years and the proceeds have paid for his 2016 insurance.

 

http://seekingalpha.com/article/2177103-the-time-to-hedge-is-now-do-it-for-less-part-i?source=author_profile_page

 

He spreads the puts out among the weakest companies in the industries in which his holdings are operating.

 

Interested to hear what you guys make of this strategy?

 

Phil

 

Thanks for the link Phil.  I read through few of his articles.  It is a very viable strategy, and as he says relatively cheap.  Basically he picks companies that are heavily leveraged in some way to the economy, and buys way out of the money puts.  He allows them to expire worthless, unless there is a significant market pullback.  He spreads them across industries.  The bulk of his 'normal' portfolio is in dividend growers, which he mostly leaves on autopilot unless they become way overvalued, and it seems unsustainable. 

 

So, recently he has shorted (via puts) capital one financial (cof) the premise here is that in a recession/pullback credit defaults in cards will rise.  The stock always tanks with the general market.

Ual - United Airlines parent - heavily leveraged to all sorts of good economic news - very vulnerable in a downturn - It is near cyclical highs and always crashes with the markets.  Why anyone would ever buy this company is beyond me. 

Gt - goodyear tire and rubber - leveraged to the auto industry

Maasco - levered to home sales and home repairs

marriot hotels - levered to a healthy economy

Generally all the companies he has picked also have greater than industry financial leverage as well. 

He has several more suggestions. 

 

I have been looking for ideas to protect my assets without going to cash, and am exploring this. 

 

In the past I have tried index puts, with little success - they tend to be expensive and decay quickly.

 

 

Uccmal,

 

Happy you found it useful. I learned something also - how to write a perfect summary  ;D

 

Phil

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