With the recent rise in volatility, there has been a lot of talk about a potential equity market crash. Many investors are nervous about when, not if, this crash will occur and are looking for some protection for their stock portfolios. Closing out your stock positions is an option, but many stocks pay dividends that the investors do not want to relinquish even when facing the threat of or during a crash. Another reason for holding on to a stock position is to avoid tax ramifications on profitable sales of securities.
The most common protection that traders/investors seek is to buy puts on stocks they are holding. The value of the put will increase as the price of the underlying stock decreases thus covering the losses in the stock position. This is easy but also very expensive as you will have to pay a premium for every put you buy for every stock that you insure.
Fortunately, there is a less expensive way to protect a portfolio. You can use the index futures contracts as a hedge for your stock holdings. Selling a future is easy if you know how they work, and selling futures is also allowed in certain IRA accounts.
Before you go out and sell the ES (the S&P 500 E-Mini futures Contract), you need to know how many contracts are needed to hedge your account. The ES is the equivalent of trading 500 shares of the SPY but at a fraction of the margin cost. At the time of my writing this article, the SPY is trading at about $277 per share. 500 shares would cost $138,500. Comparatively, the overnight margin requirement for the ES is only $6160.
You need to analyze your portfolio and determine the Beta Weighting. Beta is a measure of volatility versus the S&P 500 Index. The index has a Beta of one. If your stock’s Beta is 1.5, then it is 50% more volatile than the index. On average, (though not every day), when the index moves one percent your stock should move about one and a half percent in the same direction.
There are several easy steps to Beta Weight your portfolio:
First, you can multiply the amount you have invested in each stock by the Beta of that stock. Let’s take the sample portfolio below.
When you total the portfolio, there is $49,055 invested. Adding the result of the individual Betas multiplied by the individual investments we have $48,605.55. Dividing that by the total amount invested gives us a Beta Weight of 0.99. This portfolio has nearly the same volatility as the S&P 500, so when the market moves in a particular direction, this portfolio should move the same and in the same direction.
Using your analysis of the S&P Index, you could determine how much you expect the markets to fall to their demand. When you figure out the expected return, you could sell futures contracts to cover your losses in your stocks. In the sample portfolio, the 1300 shares have a 0.99 beta. To cover the potential losses, the investor would sell two or three S&P 500 eMini contracts to be market neutral, (1300 shares x 0.99 = 1287 and each eMini = 500 SPY shares). Two may be sufficient and three would actually profit when the market drops.
Even mutual funds have a beta, so the same can be done for a portfolio or 401k that contains mutual funds. This can usually be found on most financial websites.
Once you have found the individual betas, calculate the portfolio’s total beta using the method I mentioned previously. I have selected several mutual funds from different companies to create a hypothetical portfolio below.
As you can see, this portfolio’s beta is 1.22 and consists of 3150 shares. This means that the investor needs insurance for 3843 shares. If they were to sell S&P 500 eMini futures, seven contracts would provide insurance for the portfolio. The problem is that the margin requirement for each contract is $6160 so the insurance would cost $43,120 to insure a $137,226 portfolio. This hardly seems efficient.
Fortunately, there are additional ways to trade the S&P futures that will offer a more cost-efficient method with similar protections. I had previously mentioned that most investors will trade options to hedge a position. Specifically, they will purchase puts on shares that they own. This works for individual stocks as they are optionable. Mutual funds do not have options available however.
Since we were planning to use the S&P 500 derivatives to hedge a portfolio, we can instead use the options on the futures. This will greatly reduce the cost of the insurance for our portfolio but still provide the same coverage.
Looking at the S&P 500 eMinis options, I am using a strike price below the current price level of 2770 for the start of the hedge. You will also notice that I am using the March 2019 contract and options instead of the current July one. This is because when you trade options, you must be aware of time decay and also want to have enough time for the position to cover your hedge. If you do not buy enough time, you will lose premium and also may be forced to roll over your position which results in additional commissions.
So, the puts would cost approximately $27.50 for each eMini we want. This would be a total cost of $9,625, or 7% of the value of the portfolio. For the cost calculation, you need to understand how the futures and the options on those futures are priced. Remember that the S&P 500 eMini futures contract equals 500 SPY. This portfolio would need to cover losses in 3800 shares so seven contracts should work.
This hedge is still less expensive than buying individual puts on stock, shorting the SPY, selling the ES (S&P 500 eMini), or simply holding on. As you can see, there are several additional factors that you must be aware of. You need to know a little about options as you may want to buy a different put option due to pricing. You can also look to do the hedge in a retirement account such as an IRA so that there are different tax ramifications.
Even more important is knowing when to put on the hedge and when to remove it. You will need to know Online Trading Academy’s core strategy of market timing to learn when your portfolio is vulnerable and when to remove the hedge to let your portfolio grow. Come see what we can do to help you move out of the fear zone and become a successful investor.
Neither Freedom Management Partners nor any of its personnel are registered broker-dealers or investment advisers. I will mention that I consider certain securities or positions to be good candidates for the types of strategies we are discussing or illustrating. Because I consider the securities or positions appropriate to the discussion or for illustration purposes does not mean that I am telling you to trade the strategies or securities. Keep in mind that we are not providing you with recommendations or personalized advice about your trading activities. The information we are providing is not tailored to any individual. Any mention of a particular security is not a recommendation to buy, sell, or hold that or any other security or a suggestion that it is suitable for any specific person. Keep in mind that all trading involves a risk of loss, and this will always be the situation, regardless of whether we are discussing strategies that are intended to limit risk. Also, Freedom Management Partners’ personnel are not subject to trading restrictions. I and others at Freedom Management Partners could have a position in a security or initiate a position in a security at any time.
Editors’ Picks
EUR/USD trades weak below 1.0800 amid Good Friday lull, ahead of US PCE
EUR/USD continues its downward trend for the fourth consecutive day, driven by a stronger US Dollar influenced by the hawkish market sentiment surrounding the Federal Reserve and expectations of prolonged higher interest rates.
GBP/USD: The first downside target is seen at the 1.2600–1.2605 zone
GBP/USD trades on a weaker note around 1.2620 during the early European session on Friday. The decline of Pound Sterling is backed by the growing speculation that the Bank of England will begin the rate-cut cycle this year.
Gold ends Q1 2024 at record highs, what’s next?
Gold is sitting at an all-time high of $2,236, lacking a trading impetus amid holiday-thinned conditions on Good Friday. Most major world markets, including the United States are closed in observance of Holy Friday, leaving volatility around Gold price highly subdued.
Ripple's move above this key level could trigger nearly 50% rally for XRP
Ripple price has overcome a critical resistance level and flipped into a support floor on the weekly time frame. This development happened while XRP tightly consolidated for roughly 250 days.
US core PCE inflation set to ease in February on month as Federal Reserve rate cut bets for June mount
The core Personal Consumption Expenditures Price Index is set to rise 0.3% MoM and 2.8% YoY in February. The revised Summary of Projections showed that policymakers upwardly revised end-2024 core PCE forecast to 2.6% from 2.4%.
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