In case you hadn’t noticed, it has been a very long time since the market experienced a 20% correction. There’s also a lot of negative sentiment kicking up regarding the overall global economy from a systemic perspective.
There’s a lot of merit in the doomsday scenarios posted by a number of intelligent websites and blogs. The Fed’s quantitative easing programs don’t really appear to have accomplished much, other than arguably creating an equity asset bubble by driving down bond yields. Other economic metrics are worrisome too, such as the labor force participation rate, which is at its lowest point since 1978.
Most troubling, however, are how many companies are boosting earnings via share buybacks and cutting expenses, covering up the fact that their top lines aren’t actually growing.
There’s not much to inspire confidence. Myself? I think the market could end up anywhere between 5% in the black and 20% in the red this year, which means I have to be ready for just about anything. My preferred protection is longer-dated options.
There are a few options trades I like on the most liquid exchange-traded funds on the market. Let’s look at three of them:
Long Options for Profit: SPDR S&P 500 ETF Trust (SPY)
The simplest approach is with the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which mirrors the S&P 500, as a cap-weighted index.
You could just buy puts on the index with expiration dates that stretch into next year. In this case, with the ETF trading at $204, you can buy the Jan 2016 $200 put on SPY for $14.50.
You are basically spending $1,450 to insure a portion of your portfolio against a drop of more than 7.5% this year. So if we got that 20% correction and SPY fell to $160, you’d cash out for $4,000 plus any time premium left in the contract.
A slightly more risky choice is to sell a naked call on the Jan 2016 SPY $200 strike for $14. In this case, you are betting the SPY will not be above $200 on or before expiration, or at least, not far enough above to have the stock called away from you.
It’s risky because as a naked call, you don’t own the underlying SPY. So if it was called, you’d be forced to purchase it at the market price. You can prevent this by just buying back the call if SPY rises past your level of comfort.
Otherwise, on the downside, you collect $1,400 premium as your hedge.
Long Options for Profit: PowerShares QQQ Trust (QQQ)
The PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ) represents the Nasdaq 100. It tends to be more volatile than the SPY because it has a lot of tech stocks.
The beta, which is the relative volatility of QQQ vs. SPY, is 1.1 over the past 10 years. That means for every 1% the SPY moves, the QQQ moves by 1.1%
The QQQ trades at about $103. You have roughly the same long option plays here as you do with the SPY, in that the purchase of a Jan 2016 $100 put against the QQQ will cost about $7.50, or about 7.5%. A fall to $80 will net you a profit of at least $1,250, plus time premium.
However, because the QQQ has that higher beta, you are effectively getting the same cost to protect the portfolio against higher volatility (i.e. risk).
The naked call option here will net you also about $7.90 on the Jan 2016 expiration.
Another approach is to just hedge the portfolio against the growth stock sector. Growth stocks can also be very volatile, so by hedging against this sector, you may experience more rewards if the market tanks than if you hedge against the entire market.
Long Options for Profit: iShares MSCI EAFE Index Fund (ETF)
There’s one other way to go — international stocks have significantly underperformed compared to U.S. stocks since the bottom in 2009, with a return of 150% versus 250% for the U.S. market. You may choose to overweight international stocks this year as a hedge against a correction that is restricted to the U.S. market.
The iShares MSCI EAFE Index Fund (ETF) (NYSEARCA:EFA) is the benchmark index for many international stock funds, and has its money in very familiar foreign names, mostly allocated into the large-cap and mid-cap arenas.
EFA trades at about $61. Rather than hedge with a put, you hedge by purchasing a call, betting on out-performance. The Jan 2016 $60 call sells for about $4.20. That’s not a gigantic price to pay to go long this very popular index.
If international stocks do well this year but the U.S. market is in the doldrums, you’ll be happy to made the bet.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he was long EFA. He has 20 years’ worth of experience in the stock market, and has written more than 1,200 articles on investing. He is the manager of the forthcoming Liberty Portfolio. He can be reached at TheLibertyPortfolio@gmail.com.
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