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.

blog comments powered by Disqus
Apr 17, 2015 - 12:00am

The S&P 500 Still Not Overvalued Taking Into Account Interest Rate Environment

What we see is that outside of the depths of the 2008 financial crisis, the S&P 500 is still the cheapest it has been since around 1988. What is also evident is that the bull market that followed 1988 drove stock valuations to extremely overvalued levels but did not actually end until 2001.
read more ...

Jun 9, 2014 - 12:00am

Earnings Yield On S&P 500 Points To Higher Levels By End Of 2014

In a lower interest rate environment the required return on capital on equity investments should be lower than would otherwise be the case. The longer this environment is expected to persist the lower the required rate of return on perpetuities such as equities would logically be.
read more ...

Apr 16, 2014 - 12:00am

The Odds for a NASDAQ 100 rebound

The probability of a large loss on QQQ by June 21st, in direct contrast to IBB, is far below normal so exposing yourself to the risk is a better choice than paying a premium for protection. There is a also a larger than normal probability of a return up to 9% so a leveraged position may a good choice at this time. Therefore much better opportunities for a call option positions out of the money lie in the May 17th option chain.
read more ...

Apr 13, 2014 - 12:00am

The Sell Off in Biotech is Coming to an End

The stats also tell us that the odds are tilted in the favor of IBB for a holding period ending on June 21st. The probability of a positive investment return is above normal and the average rally is above normal. However, the risk of taking an outright IBB position is also above normal with an average drop of 15.1% in case of a negative return.
read more ...

Jan 15, 2014 - 12:00am

The Odds 2014 Will Be Just As Good As 2013

After a great year for the S&P 500 (SPY) in 2013, it's natural to wonder whether that type of pace can be maintained going forward into next year.
read more ...

Oct 17, 2013 - 8:33pm

Cumulative Performance Graph

The home page has been updated with a cumulative performance graph.
read more ...

May 27, 2013 - 10:53pm

How To Protect Yourself From Market Corrections – Or Worse

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.
read more ...

May 7, 2013 - 6:28pm

Exciting new website updates!

read more ...

Apr 11, 2013 - 9:01pm

New calculators, put option support and HTML5 revamp!

The website just got a nice shiny HTML5 face-lift. New calculators were added. Put option support was implemented and a yield curve page is now also available.
read more ...

Feb 20, 2013 - 12:00am

The Real Price Of Gold

The best way to think about gold price is to think in terms of exchange rates with gold being just another currency. The "Purchasing Power Parity" theory tells us that if the nominal price level increases in one currency (assuming no price level change in the other currency) then the exchange must deteriorate in favor of the other currency by the same percentage. In other words, the real exchange rate should always be static.
read more ...

Copyright © 2010-2021 Optionize Inc. All rights Reserved.
The information contained on this website is for information purposes only. Optionize Inc. is not responsible for the accuracy or timelines of any of the information. Please verify all prices with your broker prior to trading.