How To Protect Yourself From Market Corrections – Or Worse

Posted by Derek Tomczyk on May 27, 2013 - 10:53pm

We are now in the heading into the 7th month of a major rally in US equities. I've discussed at length why I think the US economy will continue to outperform in some of my previous articles. However, investors are now starting to ask questions about the rallies sustainability. There are in fact good reasons to believe that we've gone too far too fast. If we were to continue rising at this pace the S&P500 would end the year approx. 35% up from the beginning of the year. I just don't think the fundamentals or sentiment support this.

Another reason to be worried is the fact that the rest of the world has not joined into this US rally. I do believe that the US still has the strongest and best diversified economy in the world but no country is an island. The austerity measures implemented thus far this year by the US government are also unexpected and troubling. The full effect of the increase in payroll taxes and sequestration spending cuts is yet to be felt and the impact is likely to be negative.

All this combined with the seasonality effect (September One Of The Best Months To Invest In The S&P500) appears to be creating the perfect storm environment for US stock market indices in Q2 and early Q3.

In the end though, for most long-term investors, the issue of a possible market correction is a minor one compared to the possibility of a full out reversal of trend. While personally I think the overall bull market has a long way to go there is no such thing as a sure thing in investing. I consciously keep in mind the small probability that this will be the third top of the new century before we head lower. However, while I admit the probability of this happening, I do not worry about it, because if it does, I will come out more than alright.

How is it possible to keep a long term bullish bias, capture virtually the entire upside of any rally, while at the same time profit from any market dislocations?

The key is efficient use of portfolio protection. The way I construct my portfolio I always have some absolute downside protection but in times like these a little extra insurance may be well worth your money.

I have recently purchased out-of-the-money put options on a couple of holdings in my portfolio that have done the best year-to-date (IBB,SPY). What may be surprising is that I did not purchase the exact amount of contracts to offset my exposure. The use of option contracts with their greeks, black-scholes model and implied volatilities can be really intimidating to most investors who are not used to them. Luckily, there is a simpler, more intuitive way to determine where to buy and it's called scenario analysis.

Choosing your time horizon

The first thing to consider is when you think the correction is most likely to take place. You would then choose the expiry date closest to butafter you expect the move to complete. You could do all kinds of sensitivity analysis but the answer is always the same and intuitive. The best time period to buy is the one that matches your expected time horizon most closely. For example, if I believe that whatever correction takes place will likely complete by May 18th 2013 I would buy my contracts with that expiry date.

Sizing your bet

The second thing to consider is how much you can afford to spend on protection based on your portfolio size. The time horizon chosen above may be wrong, you may have to re-establish your protection at a later date, and you should make sure this does not destroy your overall portfolio performance. Also, if the market rallies you should still come out ahead at the end of the time period. I would suggest no more than 1% of your entire portfolio spent on insurance (preferably less).

Calculating the payoffs

The next thing to consider is how far the market would have to fall by the expiry date for the insurance to payoff and to offset any losses on your holdings. For example the following is a chart of possible payoffs for a $1000 bet in the case of a SPY drop of various magnitudes (including expected SPY prices for those drops) completing by June 28th 2013.

Establishing probabilities

The last thing to do is to decide what the probabilities are for various magnitude drops for the security for which the insurance is being bought. There are many ways at arriving at those probabilities from looking at historical data to analyzing technical, fundamentals or even going with hunches. The choice can be as easy as choosing the most probable drop magnitude and choosing the largest payoff or as complicated as assigning different probabilities to different outcomes and multiplying the expected payoffs by those probabilities.

In the above screenshot I use the simple method of looking for the highest payoff for a given drop. In the case of an expected 5% drop completing by June 28th 2013 the SPY put option highlighted in blue with a strike price of 164 is the best choice. In the case of a 10% drop it would be the yellow highlighted option with a strike price of 156, while if the market collapses 15% the best choice will be the 149 strike highlighted in green.

What it all means

Lastly, you must consider what the dollar loss in your actual holdings would be given the simulated drops discussed above and compare that amount to the expected payoffs. Will the insurance payout fully cover your loss? And if not, is the coverage acceptable? Perhaps the payout will be larger than your expected loss in which case you will actually turn a profit.

In general it does not pay to protect against small loses because the insurance is too expensive. In addition when the market is already showing weakness and the implied volatility spikes it is generally too late to buy insurance at a reasonable price. The best time to buy insurance is when the market appears to have completed a large move and has been side-ways trending for a while. The S&P 500 today (May.24) has already started showing some weakness but protection is not yet expensive. You may want to consider adding protection now or waiting to see if the market starts to trade side ways over the next week or two.

This protection calculator can help you find the right option contracts to protect your investments.

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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Exciting new website updates!

Posted by Derek Tomczyk on May 7, 2013 - 6:28pm

Today we released a large number of changes to the website hopefuly making it more useful to investors. The following are the changes:

• Revamped home page to make it easier to jump straight into the calculators
• Added a protection calculator to help investors find the right options to hedge existing positions.
• Added a free members section with automated email validation which includes some really cool matrix calculators.
• Added graphical representations of calculator results for select calculators
• Modified option indicators to start using the new put data to catch unusual put/call ratios

More frequent visitors may have noticed that some of the changes were already promoted last week. Please let us know what you think!

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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New calculators, put option support and HTML5 revamp!

Posted by Derek Tomczyk on Apr 11, 2013 - 9:01pm

The website just got a nice shiny HTML5 face-lift. The search for option contracts was completely revamped with a scenario narrative approach that we hope will be more intuitive to use. There are 3 basic scenarios that cover the most basic strategies of buying in-the-money, buying out-of-the-money and selling covered. If you have ideas for other calculators please email us and let us know. We love to hear suggestions!

Notice you can now search for both call and put options in all the calculators.

Lastly a yield curve page was added to show more than just the SPY yield curve featured on the home page. The SPY curve has proven to be an excellent forward looking indicator so hopefuly the others will be useful as well.

Dive right into the new calculators here.

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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The Real Price Of Gold

Posted by Derek Tomczyk on Feb 20, 2013 - 12:00am

This article attempts to find a way to value gold and then in turn compare this value to current gold prices.

The Real Price Of Gold

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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Selling Covered Calls On Most ETFs Guaranteed To Lose You Money In The Long Run

Posted by Derek Tomczyk on Jan 10, 2013 - 12:00am

This article outlines why using a covered call strategy is guaranteed to underperform a simple buy and hold over the long term

Selling Covered Calls On Most ETFs Guaranteed To Lose You Money In The Long Run

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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Real-World Effects Of Treating A Country's Budget Like A Household Budget

Posted by Derek Tomczyk on Nov 11, 2012 - 12:00am

This article is a continuation of the debt/GDP discussion from the two previous articles on the subject. This time I focus on pre world war II history and discuss how government policy looked like in that period and how effective it was. I also tie that experience into current world events and give a theory as to why the concepts in my articles are relatively easy to understand but hard to accept.

Real-World Effects Of Treating A Country's Budget Like A Household Budget

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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Optionize Web Site Update - New Features!

Posted by Derek Tomczyk on Oct 8, 2012 - 11:28am

One of the usability issues with the web site was that it was not very friendly to those that are not all that familiar with option contracts. The new View Investment page is an attempt to fix that by starting with ETF or stock investments that should be familiar to most investors. There are a number of statistics for the investment given on that page that are not widely available elsewhere but should have some value. The listing of the most widely held and most active contracts for the investment should hopefully facilitate a smoother transition into individual options. In addition there are a number of smaller usability changes throughout the web site.

The following visible changes were released today:

• Added View Investment page.
• Removed "all options" graphs from contract profile page since they are now on the investment profile page.
• Renamed and reflowed the menu items under the Option Tools heading.
• Changed the visualization of time-line graphs to allow for time range selection.
• Added new alerts to the Alerts page and fixed some display issues on existing alerts. The new alerts deal with totals for all contracts underneath an investment.
• Changed the alerts displayed on the front page to showcase new investment alerts.

There are also a number of important but invisible changes:

• Fixed issue that caused some expiry dates to show up as middle of the month even though they were actually end of the month.
• Fixed a number of smaller data import issues
• Prepared the web site to handle PUT options and started the data grabbing process. This is in preparation for the full PUT option suite of tools to be released in the near future

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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The Amazing Disappearing Public Debt Burden

Posted by Derek Tomczyk on Oct 1, 2012 - 10:34am

This article is a continuation of the debt/GDP discussion from the debt/GDP ratio article a few weeks back. This time I focus on history and discuss how the theoretical concepts described in the previous article hold up in real life.

The Amazing Disappearing Public Debt Burden

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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How An Individual Investor Can Take Advantage Of QE3

Posted by Derek Tomczyk on Oct 1, 2012 - 10:30am

This article attempts to illustrate how options can be used to borrow money cheaply. You can read the entire text here:

How An Individual Investor Can Take Advantage Of QE3

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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The SPDR S&P 500 Option Yield Curve Turns Positive Signaling Long-Term Demand

Posted by Derek Tomczyk on Oct 1, 2012 - 10:20am

This is an article I wrote for Seeking Alpha at the beginning of September. It relates to the option yield curve you can see on the Optionize home page. You can read the entire text here:

The SPDR S&P 500 Option Yield Curve Turns Positive Signaling Long-Term Demand

While I try to stick to the facts throughout the rest of the web site the blog is the "unplugged" piece and is entirely my personal opinion which is very likely wrong and should definitely not be used for making investment decisions.

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