Question: How can you protect a diverse portfolio without going broke?
Answer: Execute a cashless collar.
What would you think about someone who owned an expensive home but refused to insure it? This rarely happens because banks are not naïve and will not provide a home loan unless a person has proof of insurance. Yet, most investors in the stock market do not insure perhaps their single largest asset — their stock portfolios and retirement accounts.
What happens if there is another surprise economic downturn like we had in 2008, which took the Dow Jones Industrial Average from 14,000 to under 7,000? You would feel as though your uninsured home was burning down and the fire department was not answering the phone. The facts are even scarier. You would be very hard pressed to find someone whose home burned down, but almost everyone suffered significant losses in 2008.
For most, the reason for not insuring their future and security is one of three things: Ignorance, laziness or greed. This trilogy of character defects need not afflict you. You will see that, not only is hedging a portfolio easy, but it actually can increase your profitability over the long run. How do you think Warren Buffett can afford to buy shares and playfully sip a Cherry Coke when the rest of the world is panicking?
Buffett’s positions are too large for him to run into the Coke pit and purchase 3 million put options every month or quarter. Yet, with a diversified portfolio of stocks, you own your own mutual fund.
Though a whole text can be (and has been) written on the proper way in which to hedge a portfolio of stocks, the general idea is outlined here to illustrate how easy, fast, safe and necessary this process is to avoid a 50% or greater drawdown in the next market calamity. It is not a matter of if, but when, the next one is coming.
Step one: The first step is to get an understanding of the size of your portfolio. Simply add up the total dollar value of the stocks you own.
Step two: Find the index that most closely matches up with your group of stocks. If most of your stocks are small growth companies, then the Russell might be a good choice as a hedge. If you have broad exposure to the market, then the S&P 500 would work. Larger cap companies in your portfolio might make the Dow a more viable product via the DJX (1/10th mini Dow index) or DIA (an exchange-traded fund) index. The DJX would be the best option for our portfolio (below).
Step three: Because options on stocks and indexes typically have a 100 multiplier, we need to multiply the price of the index you are using by 100. Then simply divide the total dollar value of your portfolio by 100 times the index you are looking to utilize as a hedge. If your portfolio is worth $35,663.52, you simply divide this number by the DJX value of $135.71 (as of Oct. 5) X 100, or 13,571 (Portfolio / (Index X 100); $35,663.52 / (135.71 X 100) = 2.6 options.)
This means that you will need to purchase either two or three puts to hedge this portfolio. Most people round up in bearish times and round down in bullish.
Step four: Find the appropriate put in the index to purchase for a hedge. Though an at-the-money put will provide the most protection, it also is the most expensive (in terms of time value) and you are not trying to eliminate all risk, just risk of ruin. For this reason most people go slightly out-of-the-money. Although there are statistical methods you can implement to select the best put, many people look at a 5% to 8% window.
With the DJX at $135.71 on Oct. 5, the November 133 put (with 43 days until expiration) is trading at $1.50. Three put options will cost $1.50 per share X 100 shares per contract X 3 contracts, or $450.
That gets quite expensive to maintain constant protection so we will look to sell calls or call spreads against this to offset most of the cost — thus creating a cashless collar. This simply is a long put and short call that protects long stock. It is usually done for as close to no cost as possible.
Suppose that the market crashed 10% between now and expiration, causing the DJX to close at $122.14. Our portfolio of stocks also would drop by about 10% if diversified (some stocks more and some less). The value of the portfolio would now be about $32,097.17, a $3,566.35 loss. Yet our 133 puts would be $10.86 in-the-money. This recoups almost our entire loss because $10.86 of intrinsic value X 100 multiplier and 3 contracts = $3,258.
Although this was an oversimplification of the process, actual hedging is not much more difficult. Choosing the right index, expiration month and strike prices can go a long way to protect your portfolio the next time an MF Global, Enron, Lehman Brothers or Wachovia occurs.
J.L. Lord is an analyst and author for RandomWalkTrading.com.