Buying Umbrella's When It's Sunny Out

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Sunny With A Chance Of A Rain

Those of you who've been to Manhattan when it's raining will be familiar with the sight of people selling umbrellas on the street. You generally don't get the best prices on umbrellas on that situation - you're better off buying one in a store when it's sunny out and having it with you when it starts raining. Hedging the market when it's trading near all-time highs is somewhat analogous: it tends to be cheaper. 

It also helps that volatility has come down since spiking earlier this year. 

Chart

Below we'll look at a couple of ways you can further lower your cost of hedging. First, let's run through the basic approach of hedging a portfolio against market risk.

Setting Initial Conditions

For the purposes of this example, we'll assume your portfolio is worth $500,000, and that it’s closely correlated with SPY. We'll also assume you have enough diversification within it to protect against stock-specific risk, and that you can tolerate a decline of up to 20%. If you have a smaller risk tolerance, you can use the same approach entering a smaller decline threshold, Similarly, if you have a larger or smaller portfolio, you can adjust Step 1 below accordingly. If you have gold, bonds, or other asset classes in your portfolio, we'll address that at the end.

Hedging Stock Market Risk

Step 1

Divide the dollar value of your portfolio by the current price of SPY. 

Step 2

Scan for the optimal, or least expensive, puts to protect against a >20% decline in your number of shares of SPY. The first time we do this, we use our default time to expiration, which is approximately six months out. 

Step 3

Round up the number of SPY shares to the nearest 100 and repeat step 2.

Step 4

Experiment with shorter times to expiration, to see if you can lower the annualized cost as well as the cost over the time period you use. Note the tradeoff of using a shorter time to expiration: you may have to roll your protection when it's more expensive to do so. 

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