Equity Market-Risk Hedges
It's mid-2008 and you have an investment portfolio (probably several, as a professional manager) with $1 million in equities. You don't like the looks of the market, which has drifted down -10% from its top a year ago.
You want to get some insurance against further market deterioration. What's the best way to do it?
Let's assume there are no restrictions against buying Puts. On June 30, 2008 the 3-month, at-the-money (1275 strike) S&P 500 SPX puts cost $60. The usual delta, or expected change in option price for change in at-the-moneys is .5 or 50 cents on the dollar.
If you would like to buy market protection to shield half the equities' value, you need $1 million worth of notional value, or 785 puts, at a cost of $47,100. Hmmm. Pretty expensive, but could be worth it - nearly -5% to save ??? %.
Well, it paid off. The puts were worth $380 apiece the week before expiration in October, so their $251,000 profit (25% of $1 million) did largely offset a -30% loss in the portfolio, leaving the total at $950,000. A not-hedged portfolio is $702,000.
But was there a better way?
Instead, suppose you bought $300,000 of SDS, the inverse, 2x leveraged S&P 500 index ETFs, on June 30th. By the same time as the cash-out of the puts, they would be worth $500,000. The remaining $700,000 of the original portfolio would have sunk to $490,000, combining to a total of $990,000.
That $40,000 advantage over the puts is just the start. What to do next? The market in October '08 looks like it is in near free-fall, not likely to see a big recovery soon. Do we need continuing downside protection?
More puts here to get the same coverage will cost $103,000 for 3 month at-the- moneys (now 900s), over twice the earlier cost because of the market emotions at the time. Three months later in January much of that fear has subsided and their $26,000 value creates a $-77,000 loss. The market's further erosion produces a puts-hedged portfolio value of $884,000. The un-hedged portfolio is $695,000.
Meanwhile, the SDS investment, kept at the same 30% of a $990,000 total has helped to sustain that portfolio's market value during the period at $905,000.
It's now early in the new year and huge banks have become almost penny stocks, unemployment is rising, consumers are on a buying strike, and politicians are throwing money at anyone who will beg. Except investors. January '09 is still an environment crying for market protection.
Then 3-month at-the-money puts, to provide a continuing proportion of portfolio protection, can be had for $78,400. But by their expiration week in April, that had dwindled to $52,800 and a loss of $25,600.
The puts-hedged portfolio is now worth some $820,000, still far better than an unhedged market portfolio with a value of only $670,000. Its loss: -33%.
But the portfolio of 70% stocks and 30% ETFs has been shielded to a market value of $862,000. Its maintenance involved only simple share transactions in a familiar, very liquid market. No special knowledge was needed of complicated price relationships between strike prices and expiration dates, and no tricky executions to be followed and filled in narrow markets, saving time to be spent with clients.
And as a special bonus for the ETF-hedged portfolio, consider the attached picture. At those times when concerned investors are most likely to ask about their portfolios - because the market is rapidly sinking - their total equity values are typically steady or rising.
