Investing under normal conditions carries risk — that’s why there is a reward. But these days, that concept stretches to the extreme from all kinds of weird angles. I’ve been trading for decades, and this is by far is the most interesting market I’ve ever seen — and by interesting I really mean completely without rhyme or reason. The risks remain extremely high. It is high time that investors looked to buy stocks to hedge your portfolio.
Equities are breaking records every week. The small-capitalization stocks have rallied 125% since the middle of March. All this while the whole world is still reeling from the effects of the pandemic. Small business America cannot even keep its doors open by order of the states. I live in California and I can’t even get a haircut.
In spite of all of this, I cannot even convince investors to buy insurance on their portfolios.
I am certain that most of you already know the tickers I propose today. My goal is to motivate the investors to get some insurance. We all have coverage for our other assets like cars and homes. We even pay small fortunes every month to have healthcare insurance. But when it comes to covering our nest egg, most investors deem it superfluous.
For the next few weeks, I believe there is a high chance of a correction. Because of this, I want to balance my portfolio with a few bearish setups.
The job of hedges it to buy me time on bad days so I can stop the bleeding without much pain. Today we will look at three ways to do this, though they are definitely not the only ways. The easiest way is just to book some profits. Another direct way of protecting a portfolio is by buying specific puts in the stocks I own. This can get expensive though, especially if I maintain a long list of tickers in my portfolio.
This brings me to today’s alternatives. They are blanket coverage like an all-inclusive policy across the whole market. The three tickers are
- CBOE Volatility Index (INDEXCBOE:VIX)
- iPath Series B S&P 500 VIX Short-Term Futures ETN (BATS:VXX)
- iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT)
Before we proceed I assure you that I am not a fear monger. I do write about both sides of the equation. Here is one that called for shorting these tickers when it was appropriate. Investors who won’t entertain caution at record highs and maximum risk are being reckless. If the markets continue rallying and I lose a little bit of money on the protection so be it.
Stocks to Hedge Your Portfolio: CBOE Volatility Index (VIX)
If you’ve watched CNBC even just once during the last decade then you must know that they refer to the VIX as the “fear gauge.” While technically that is correct, I argue that this is now false term for it. After the initial shock of the virus outbreak, there has been absolutely no fear on Wall Street. Yet the VIX remains almost double its mathematical average.
In the meantime, investors cannot get enough of buying risky stocks.
Consider the electric vehicles (EV) craze. Simply because they promise future production of EVs they now have billions in market cap. Case in point Nikola (NASDAQ:NKLA) which is pre-revenue now has a market cap of almost $8 billion. In addition, its very legitimacy is still in question after many scandals and the ousting of a founder. I am not picking on one specifically but rather using it to illustrate the point: Scared markets do not rush into uncertain stocks like they are now.
All this is happening while the world faces the worst economic conditions ever. Much like the CPI can no longer measure inflation correctly, the VIX is a broken gauge. However it will provide protection if the indices selloff.
Notice I didn’t say provide profit, because the point today is not to short the market, but to hedge your portfolio. On Wall Street panic days, equities suffer great losses, and any profits coming from a VIX position merely offset some (not all) of the pain.
The advantage to using the VIX is that it has held its value much better than other bearish vehicles. It hasn’t closed below $20 for almost a year. If I buy call options in it they’re likely to hold their value even on up market days.
iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)
A cousin to the VIX is the VXX. The difference is that this one is an exchange-traded note (ETN). Over time, it loses its value so it’s not smart to own it for long. However, for short stints, owning the VXX provides for excellent protection if things go south on Wall Street.
The tricky part here is timing it properly because of how quickly it loses value. By looking at long-term charts of the VXX stock, we quickly realize that it’s not something I want to hold for any longer than a few days. I tend to use this for an immediate hedge — perhaps overnight.
Buying calls in the VXX would accomplish the goal to hedge your portfolio. But you better be nimble managing that risk in the near term. A few hours of upside price action in equities can quickly dwindle the efficacy of the hedge.
So why bother with this tool versus the other? Not all portfolios are the same, so this may work for some better than others. It is important for us to know the speed with which we trade, else we could choose the wrong protection vehicle.
For example, I am actively trading every day but I prefer more stable setups. If the correction doesn’t come, the VXX calls I bought would lose their value too quickly for my taste. I prefer using the VIX so I don’t have to revisit my protection every day.
iShares 20+ Year Treasury Bond ETF (TLT)
The third method of protecting a portfolio is not as obvious as the other two, but it works. Often enough, equities and bond prices move in opposite directions. This is especially true on panic days. The easiest way to participate in this hedge is to buy the TLT. It is very liquid and it’s easy to get in and out of it or its options.
If you doubt the effectiveness of this method, just look at the TLT chart during the pandemic crash last march. The stock price of it went to $180 per share. It has since given up the whole rally and it’s now back to base. Buying the TLT or TLT calls now effectively hedges your portfolio against another panic crash.
Last year the correction reversed too quickly because the government intervened with massive amounts of money. They can’t afford to do it again.
If something breaks on Wall Street this year, the markets will not likely recover as swiftly as they did in 2020. The bar is now high for the stocks that led the rally out of the March lows. Investor expectations are very aggressive, and the least bit of disappointment will create a lot of selling.
Owning bonds works and it’s a hedge that’s going to hold its value well. What helps to make this happen is the acronym TINA (there is no alternative). The U.S. Bonds are the only place to park money for a reward. Bonds abroad carry negative rates so it would cost investors money to own them. This will keep a bid under the TLT for as long as that is the case.
On the date of publication, Nicolas Chahine did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Nicolas Chahine is the managing director of SellSpreads.com.