Work-Free Wealth

Income Investing for Financial Independence and Early Retirement

Hedging your portfolio – or tough out the next bear market?

With the bull market in its 8th year and stock market valuations stretched by most measures, for people who have been around bear markets (myself included) the fear of a looming market drop is increasing.  I have to admit the prospect of sitting on the sidelines and watching my portfolio balance get cut in half is very unappealing.   It’s only natural to think about hedging my portfolio.  And there are lots of good reasons.  The Shiller PE stands at a dizzying high of 33.8.  The only time it was higher was before the 2000 Dot.com crash when it reached 44.19 (Dec 1999).  Hedging seems like a pretty easy way to deal with market anxiety.  However, one way that I would not recommend is establishing stop loss orders to sell your positions when the market drops by a certain amount since that could backfire.  You may sell much lower than your limit in case of a flash crash or overnight drop.  It also means that you are potentially creating a large tax bill for yourself by realizing capital gains.  That is why I think hedging with put options is a pretty clean and easy way to protect yourself from a large market drop.

Hedging with Put Options

Buying a put option is a classic and easy way to profit when the market drops.  If you buy a put option, you have the right to sell the underlying security at a given price (strike price).  Let’s say you buy a put option on the SPDR S&P500 ETF (SPY).  You choose to buy the put option with a strike price that is 5% below the current SPY price to lower the cost. The expiration date is a year from now to protect for the entire year.  If the put option costs $10, you will pay $1000 ($10 * 100 shares) since each option contract is for 100 shares of the underlying security.  If the market goes up further, your portfolio keeps growing and your “insurance” cost was limited to the cost of the put option.  If the market drops, your loss on the protected 100 shares is limited to the cost of the put and the difference between the initial value and the strike price.  Obviously, there are more sophisticated strategies but the basic premise that hedging costs money remains.

Source: CBOE

Why I am not hedging

While buying protection for the portfolio sounds pretty good, timing the hedge is difficult at best.  The longer out the expiration date, the higher the option price (time premium).  This means you have to know a) when to buy the put option, and b) when to sell it if the market drops.  The market could drop a lot and then recover.  If you hang on to the put option, it will still expire worthless if the market recovers.

All of this might still be worth the hassle if you had a clear and objective indicator when the market might drop.   Unfortunately that does not exist.  Let’s take the yield curve as an indicator.  The inverted yield curve is defined as the longer term Treasury interest rate being lower than the short term Treasury interest rate.

Source: Federal Reserve Bank of St. Louis

When looking at the chart of the yield curve spread, it seems that yield curve inversions are pretty well correlated with looming recessions.  When digging some more into the data, the time lag between the yield curve inverting and the market dropping can be quite long.  So, it may be a good leading indicator but the time signal is still off.   I do admit that I am worried about an inverting yield curve but it is not actionable for me.

For now, I have decided to just tough it out instead of spending money on hedging.  After all, the market moves up more often than not, and that is the reason to be invested in the first place.

 

 

 

 

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