How To Limit A Bear Market's Bite
Years Of Bear Market Predictions
As the current bull market has continued, there has been no shortage of predictions of its eventual end. One of the latest predictions appeared in a recent MarketWatch article by Phillip van Dorn ("Get ready for a ‘destruction of wealth' as stocks head toward a bear market"). In that article, van Dorn referred to an indicator called the Guardian Gauge:
"A new health indicator for the S&P 500 Index of the largest U.S. stocks shows a rising likelihood of a broad, long-term decline."
Reality Shares, a San Diego-based firm founded in 2012, has a new market-health indicator called the Guardian Gauge, which uses volatility and price-momentum data to give a long-term outlook for the S&P 500.
For the past 15 days, the Guardian Gauge has been in the red.
The Problem Presented by Bear Market Predictions
The problem presented by bear market predictions such as the one above is what to do with the information, particularly when we're not given a time frame when we can expect the bear market to begin. If you got out of the market at the first one of these predictions, you would have missed most of the current bull market. On the other hand, if you do nothing to protect yourself, and the prediction comes to pass soon, you may regret your inaction. A solution to this problem is to stay invested but limit your market risk. First, we should clarify the difference between market risk and idiosyncratic risk.
Market Risk versus Idiosyncratic Risk
In a portfolio comprised of common stocks, idiosyncratic risk can also be thought of as stock specific risk: it's the risk of something bad happening to one of your stocks, for example, the chance that one of the companies you own shares of may be forced into costly recalls and litigation, as in the case of Volkswagen (OTC Markets:VLKAY) was recently.
Market risk (also called systemic risk) is the risk of a decline in the market as a whole, as happens during crashes and bear markets. Since most stocks decline in those cases, market risk can't be limited via diversification. In order to limit market risk, you need instruments in your portfolio that will go up in value when everything else is going down. These instruments are called hedges.
Hedging Market Risk
If your portfolio is diversified enough so that your idiosyncratic, or stock-specific risk has been ameliorated, you can hedge market risk by buying optimal put options on ETFs that track relevant indexes. Puts (short for put options) are contracts that give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost.
Step One: Choose A Proxy Exchange-Traded Fund.
Although mutual funds and some stocks can't be hedged directly, you can still hedge a diverse portfolio of mutual funds against market risk by buying puts on a suitable ETF. The first consideration is that the ETF will need to have options traded on it, but most of the widely traded ETFs do. The second consideration is that the ETF be invested in the same asset class as your portfolio. Let's assume your portfolio consists of large cap US stocks, or mutual funds that invest in them. An ETF you could use as a proxy would be the SPDR S&P 500 Index (NYSE: SPY), or the SPDR Dow Jones Industrial Average (NYSE: DIA). In the example below, we'll use SPY.
Step 2: Pick A Number Of Shares.
To hedge an equity portfolio against market risk, you would want to hedge an equivalent dollar amount of your proxy ETF. By dividing the dollar amount of your portfolio by the current share price of your proxy ETF, you can get a number of shares of the ETF that you need to hedge. Bear in mind that options contracts cover round lots of shares (generally, a round lot = 100 shares), so if your number of shares includes an oldd lot, you can either hedge the next highest round lot of shares, or slightly over-hedge the next lowest round of lot of shares.
Step 3: Pick a Threshold
Threshold, in this context, means the maximum decline in the value of your position that you are willing to risk. All else equal, the larger the decline, the less expensive the hedge, and vice-versa. In some cases, a threshold that's too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge against. I sometimes use a 20% decline threshold when hedging equities, an idea borrowed from a comment by fund manager Dr. John Hussman:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Step 4: Find the Optimal Puts.
Given the time frame over which you are looking to hedge, you'd want to find the put options that would protect you against a greater-than-X% decline (where X is your threshold) at the lowest cost. When doing so, you'd want to keep in mind the cost of the hedge: if, for example, you can only tolerate a 20% decline, and there's a put option with a strike price 20% below the current market price, but it would cost 5% of your portfolio to buy it, then you're actually risking a 25% decline in that case.
An Automated Approach
Here we'll use a hedging app to facilitate finding the optimal puts for an investor with a $200,000 portfolio invested in large cap U.S. stocks, who is unwilling to risk a decline of more than 20% over the next several months.
Since our investor is in large cap U.S. stocks, we'll use SPY as a proxy ETF. So we enter "SPY" in the Ticker Symbol field in the screen capture below. On Tuesday, SPY closed at $197.79 per share, so to get our number of shares, we'll divide $200,000 by $197.79, and enter the result, rounded to the nearest share ("1011") in the Shares Owned field. In the Threshold field, we enter the largest decline our hypothetical investor is willing to risk over the next several months, in percentage terms ("20").
We tap "Done", and a few moments later, are presented with the optimal puts:
As you can see at the bottom of the screen capture above, the cost of this hedge was $2,470, or 1.24% of our investor's portfolio value. Note that, to be conservative, the app calculated the cost using the ask price of the puts. In practice, you can often by puts for less (i.e., at some price between the bid and the ask), so the actual cost of this hedge would likely have been less.
How This Hedge Would Protect Your Portfolio
Remember, the reason we picked SPY in this case is because our hypothetical investor's funds were invested in blue chip US stocks. If those fund drop in value due to a market decline, most likely, the S&P 500 Index will have dropped in value as well. And if the S&P 500 has dropped, so will the ETF tracking it, SPY. If SPY drops more than 20% - if it drops 20.5%, 30%, 40%, or even more – the put options above will rise in price by at least enough so that the total value of a $200,000 position in SPY + the puts – the initial cost of the puts will have only dropped by 20%, in a worst case scenario.
Hedging A Portfolio Of Stocks And Bonds
The example above is simplified in that we've assumed our hypothetical investor's portfolio is entirely invested in equities. But what if he has some bonds or bond funds? In that case, we could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, we could use one per asset class. So, for example, if 60% of the investors assets were in blue chip US stocks, and 40% in investment grade corporate bonds, we might scan for optimal puts on a number of shares of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE: LQD) equal to 40% of the portfolio value.
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