Hedge Against a Market Crash With Index ETF LEAPS

by Lawrence Meyers | February 26, 2014 9:31 am

Hedge Against a Market Crash With Index ETF LEAPS

It’s common to have experienced a huge upside-market year, then start to worry about your portfolio. That’s why they call it the “wall of worry” when stocks do nothing but go up — the anxiety of when it might all crash down can become very powerful.

crash185 Hedge Against a Market Crash With Index ETF LEAPS2013 was a blockbuster year, and 2014 got off to a wobbly start. Naturally, investors are worried. If you’re among the troubled and are wondering about ways to hedge your portfolio, I suggest options … and have a few ideas about how you should start.

Regardless of whether you have many stocks in your portfolio or just a few equities or index ETFs, you can use index Long-Term Equity Anticipation Securities, or LEAPS — basically long-dated options — to hedge against the entire portfolio. You can either buy puts against the entire index, or if you hold some index ETFs, you could sell covered calls against them (you’ll see in a moment, however, why I don’t like the latter choice). By using LEAPS, you are using expiration dates that stretch into 2015 for index funds.

Index ETF LEAPS: SPDR S&P 500 ETF (SPY)

Let’s take the SPDR S&P 500 ETF (SPY[1]), an index ETF which holds the S&P 500 stocks in its portfolio. The SPY currently trades at $185.39.

Let’s select the January 2015 expiration date. Which strike price might be a good choice? The further out of the money you go, the less expensive your insurance policy, but the more you’ll lose before it kicks in. I personally assume that the market is going to have some volatility as part of its normal operation — it isn’t a 10% correction of SPY that scares me, but a crash, especially of 20% or more. So I choose a strike price at least 10% below the current price, which would put us around $166. The January 2015 $166 Put goes for $5.35. Therefore, it costs $535 to protect $16,600. I think a cost of 3.2% of the entire portfolio to protect against a crash is a reasonable price to pay.

You can also use covered calls, but they’re not as clean a hedge.

The problem with a covered call is that you might be trading upside for that insurance. That requires you to guess how much the market might advance at a maximum this year.

Let’s say you think SPY will hit $200. Then let’s say you sell the Jan 2015 $200 call for $2.70. You pick up about 1.35% in premium, and you’ve given yourself about 9% upside to capture. However, if at any time SPY goes over $200, it might be called away. If the market rallies beyond that, you won’t participate. Furthermore, that $2.70 in income is only going to give you a 2% downside cushion. If SPY falls more than what you collected in premium, you’ll be in the red.

I want to protect against big drops, not little ones that might reverse the next day. Therefore, stick with puts.

Index ETF LEAPS: PowerShares QQQ Trust (QQQ)

Let’s use the put strategy on another index fund, the one representing the Nasdaq-100: PowerShares QQQ Trust (QQQ[2]). This index ETF is trading at $90.31. The Jan 2015 $80 put costs $2.52. So you have a 10% gap where you’ll accrue losses, but then the put protects you below $80. Once again, the cost is $252 to protect $8,000, or about 3%.

Index ETF LEAPS: SPDR Dow Jones Industrial Average ETF (DIA)

Perhaps you are a fan of the Dow Industrials index ETF, the SPDR Dow Jones Industrial Average ETF (DIA[3]). This index ETF is trading at $161.54. The January 2015 $145 put costs $4.40. So you have a 10% gap where you’ll accrue losses, but then the put protects you below $145. The cost is $440 to protect $14,500, or about 3.2%.

As of this writing, Lawrence Meyers[4] did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc.[5], which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books[6] and blogs about public policy, journalistic integrity, popular culture, and world affairs[7]. Contact him at pdlcapital66@gmail.com[8] and follow his tweets @ichabodscranium.

Endnotes:
  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  2. QQQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=QQQ
  3. DIA: http://studio-5.financialcontent.com/investplace/quote?Symbol=DIA
  4. Lawrence Meyers: mailto:pdlcapital66@gmail.com
  5. PDL Broker, Inc.: http://www.pdlcapital.com/
  6. written two books: http://www.investorplace.com/author/lawrence-meyers/
  7. blogs about public policy, journalistic integrity, popular culture, and world affairs: http://www.ichabodscranium.com/
  8. pdlcapital66@gmail.com: mailto:pdlcapital66@gmail.com

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