Nobel Laureate: Market Rally "Could End Badly". Two Ways You Can Hedge.

"That Could End Badly"

Another week, another warning: this time it was Nobel laureate economist Robert Shiller:

"I am not yet sounding the alarm. But in many countries stock exchanges are at a high level and prices have risen sharply in some property markets," Shiller told Sunday's Der Spiegel magazine. "That could end badly," he said.

As I noted in a recent post, the trouble with bubble predictions is if you got out at the first mention of one potentially bursting, you would have missed out on much of the recent run-up. An approach that lets you stay invested while limiting your potential downside is to buy and hedge. Here are inexpensive ways of hedging against double digit and a single digit declines, respectively, in the SPDR S&P 500 ETF SPY

1) Hedging With Optimal Puts

0.75% cost. Uncapped upside.

These were the optimal puts, as of Monday's close, to hedge 1000 shares of SPY against a greater-than-20% drop over the next several months.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 0.75%.

2) Hedging With An Optimal Collar

0.99% cost. 5% upside cap.

Hedging against single digit declines with puts can be expensive, but if you are willing to cap your potential upside, you can reduce the cost of hedging significantly. If you were willing to cap your potential upside at 5% between now and June 20th, this was the optimal collar** to hedge 1000 shares of SPY against a greater-than-8% drop over the same time frame.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.99%.

Note that, to be conservative, Portfolio Armor calculated the cost of this hedge by using the bid price of the call leg and the ask price of the put leg. In practice, you can often sell calls for more (at some price between the bid and ask) and buy puts for less (again, at some price between the bid and ask), so, in actuality, an investor opening the collar above may paid less than $1780 to do so in this case.

Possibly More Protection Than Promised

In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this post about hedging shares of Tesla Motors, Inc. TSLA.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.