Market Collapse? Never Been This Cheap To Protect Your Portfolio Using This Strategy, Experts Say

Zinger Key Points
  • "It has never cost less to protect against an S&P drawdown in the next 12 months," Bank of America says.
  • In the current context, high stock-market valuations and still-high interest rates make acquiring cheap option puts appealing.

Financial safeguard tools are on sale these days and protecting your portfolio against sudden stock market declines, or simply speculating on them, has never been as cheap as it is now.

This insight comes from the Global Equity Derivatives Research team at Bank of America, which recently published a note analyzing the cheapness of market hedging costs.

“Since our data began in 2008, it has never cost less to protect against an S&P drawdown in the next 12 months, as high rates align with low implied vol and correlation to offer a historic entry point for hedges,” analysts at Bank of America stated.

Traditionally, there are several ways to hedge against market downturns, including investing in cash assets like short-term U.S. Treasury bonds, such as the iShares 1-3 Year Treasury Bond ETF SHY, buying volatility (VIX), as tracked by the Proshares Trust VIX Short-Term Futures ETF VIXY, or purchasing put options on stocks and indices. Among these, the put option stands out as having the highest potential gains should the market experience a significant downturn.

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How Does A Put Option On The S&P 500 Work?

Put options are financial derivatives that grant the holder the right, but not the duty, to sell the underlying asset (in this case, the S&P 500 Index) at a predefined price (known as the strike price) on or before the expiration date.

When an investor buys a put option on the S&P 500, they are essentially taking a bearish or protective stance on the market, hoping to profit from a decline in the value of the S&P 500. The buyer of the put option pays a premium to the seller (also known as the writer) for the right to have this option.

In practical terms, purchasing a put option is similar to securing insurance against a negative financial occurrence. If the unfavorable event doesn’t transpire, the investor is responsible for the option premium (expense). However, if it does happen, the investor stands to gain a significant return.

  • If the S&P 500 falls below the option’s strike price before it expires, the put option gains value.
  • An investor can profitably sell the S&P 500 at a higher price (the option’s strike) even if the market price is lower.
  • The difference between the option’s price and the market price, less what you paid for the option, is your potential profit.
  • If the S&P 500 remains above the strike price or rises during the option’s validity period, the buyer’s maximum loss is restricted to the cost of the option.

Bank of America Recommends Buying Long-Term Puts On The S&P 500

Bank of America emphasizes in the note that the current all-time low cost of protection is especially notable in a climate of 3-4% inflation, a real threat of recession, and high stock-market valuations despite still elevated interest rates.

The derivatives research team believes it is now “sensible” to purchase longer-dated S&P put options.

These contracts are currently trading at prices even lower than those seen in 2017, a year marked by unprecedented stock market tranquility, including the lowest ever recorded Volatility Index (VIX).

 “We continue to warn against rising fragility risk and favor a barbell approach to risk: participate but hedge the tails while waiting for the shock,” Bank of America wrote.

Chart: CBOE S&P 500 PutWrite Index* At All-Time Highs, VIX Nearing All-Time Lows

*The S&P 500 PutWrite Index is a financial index that tracks the performance of an option strategy known as “put writing” on the S&P 500 Index. This technique entails selling, or “writing,” S&P 500 put options. When an investor sells a put option, the buyer of the put pays a premium (the option’s price).

Now Read: PCE Report Signals Easing Inflation: Top Wall Street Economists Weigh In On Market Implications

Photo: Shutterstock

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