The stock market is presently at its third most expensive in history, exceeded only by the market before the 1929 crash and the dot-com bubble in 1999. That means that everyone is happy! Things are grand! That is, until something comes along and takes the air out of the market.
If you own a long-term diversified portfolio, you can just ride out the ups and downs of the market. Still, I recognize that some investors are hunting for some kind of hedge. That’s where options can come in handy.
You can use a wide variety of options to hedge your long positions. They come with a cost, of course. But that’s the case with all insurance, which is what options for hedging usually are. I actually prefer to take short positions of varying kinds, but I recognize that this has unlimited risk associated with it.
So think about these as possible selections for a market crash.
Hedging With Options: ProShares UltraShort S&P500 (SDS)
One way to actually hedge a market crash is by going short. A very aggressive tactic is to buy the ProShares UltraShort S&P500 (NYSEARCA:SDS).
This ultrashort exchange-traded fund means that, if you buy it, you are going short the entire S&P 500, but doing so in leveraged fashion, so you are actually getting triple exposure to the index on the short side. That’s right — you are going long an exchange-traded fund that shorts the market with triple leverage.
That may make you queasy, which is why buying call options on this ETF is not a bad idea. Remember, since you are going long an ETF that shorts the index, you want to be long the call options. It also limits your risk, since you just buy the calls and that’s all the money you spend.
The 15 Sept $13 calls can be had for only 77 cents. With SDS trading at $13.15, you will end up in the black if the S&P 500 falls even a little off its current price.
Hedging With Options: iShares Russell Mid-Cap ETF (IWR)
Another way to go, even in addition, is to buy puts on the iShares Russell Midcap Index Fund (ETF) (NYSEARCA:IWR). The concept here is that smaller stocks are often more subject to both volatility and corrections when the market takes a dive.
That’s because these stocks have lesser legacy cash flows than large-cap stocks; and because they are still growing, they may not weather storms quite as easily. Thus, small-cap stocks may fall more in a broad correction than larger stocks, which are perceived as being safer.
With IWR trading at $190 per share, it’s going to be costly to purchase puts. Still, if you are concerned enough, the cost may be worth it. In fact, I might even buy puts in groups of two, and do so with out-of-the money options.
Consider buying the 18 Aug $179 puts for $2.50. That means you’ll profit if the IWR falls more than 10%. With pairs of puts, you can sell one part of the pair at a certain price and the other if the IWR falls even more.
Hedging With Options: Dow Jones US Technology ETF (IYW)
The same idea of volatility and fear applies to tech stocks. When things get bad, people rush for the exits. Technology stocks are usually growth oriented, and growth stocks historically get hit harder in declines.
The other thing about tech stocks is that they must constantly be on the move with respect to R&D and expenses to remain competitive. A market crash engenders fear, and that fear extends to the overall economy. So if investors fear the economy is slowing, even if the fear is irrational, they’ll want to get out.
The iShares Dow Jones US Technology (ETF) (NYSEARCA:IYW) holds many of the large-cap tech stock names that exist in many portfolios. In a broad decline, people will sell first and ask questions later. Suddenly holding a stock that trades at 200 times earnings will feel like a really bad move.
The ETF trades at $137. Look at buying the 15 Sept $135 puts for for $3.85, which means you’ll be in the black after only a 3% decline.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.