The mere suggestion that the Federal Reserve might consider tapering off its quantitative easing program, in which it purchases $85 billion of bonds each month, sent the market tumbling a few weeks ago. So can you imagine what will happen when it actually announces it really is going to taper?
One hopes that will be a case of “sell the rumor, buy the news” … but I don’t think so.
Fed Chairman Ben Bernanke is no idiot, so if and when he does tap the brakes, he will tap them. The tapering will be very gradual, with the intent to avoid a stock market crash. Just like people moved out of bonds and into stocks, the reverse will likely hold true — people will move away from higher-risk equities, seeking yield and heading back into bonds.
It’s important to understand that the bond markets are gigantic in comparison to stocks, so there’s a heck of a lot of capital that has come into the equity markets that will then pack up and leave as bond yields begin to rise again.
I expect the markets will fall — possibly at a gradual rate that will be offset by any natural increase in the growth rate of various companies. However, so many stocks are well beyond fair value that I don’t think that will provide much hedge.
That leaves options as one method to hedge against the inevitable collapse — whether that collapse is rapid or more of a slow drip. There are a few ways to handle this.
The first is to just hedge against the entire market with puts. I’m not crazy about this idea, though, and here’s why:
Perhaps you want to protect against a 20% drop. In that case, you probably want to buy a put that is at least 18 months out, that will increase enough to offset a 20% decline in your portfolio. So if you have a $50,000 portfolio, you’ll want something that will pay you $10,000 in the event of a 20% correction.
Look at the SPDR S&P 500 (SPY), which trades at $164 as I write. The January 2015 $164 put is trading at $15, thus it will cost you 3% of the total value of your portfolio to buy this protection. If the market falls 20% before that expiration date, this ETF will be trading at $131. You could then sell the put for $33. The total gain will be $1,800 (plus any time premium left if that target is hit before January expiration, at roughly a rate of $50 per month in advance of that date). But since you only offset a $10,000 drop by $1,800, you’d actually have to buy six contracts. Uh oh. Now you’ve spent about 12% of your portfolio to protect against a 20% loss. The cost of this solution is just too high.
Instead, if you really believe the path of least resistance is down, and you don’t want to just gradually sell 20% of your holdings by dollar-cost averaging out, look at selling calls against your most overvalued stocks.
For example, Whole Foods Market (WFM) is a terrific company selling at 39 times earnings. That’s way overvalued. If you are willing to have your shares called away, and possibly buy them back at a price that isn’t too far above where you sold, you could sell rolling covered calls. The premiums you collect will be cash raised against a position that might keep falling. Whole Foods trades at $54.65. The August 55 Calls are selling for $2. If you manage to sell this call six times, that’ll be a 22% return, effectively hedging your 20% correction.
You might think it’s impossible to sell calls that many times, but I assure you, I’ve done it. Not all options will give you a 3% premium, but even at 1.5%, patience and discipline will deposit a lot of cash in your account, even as the stock falls.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets at @ichabodscranium.