Cheapest way to buy downside protection

[Cevian]

I keep reading about various fund manager who were able to purchase downside protection in 2008 by way of Credit Default Swaps for pennies on the nominal dollar of the bonds they sought protection on. I just don't see these types of opportunities available. For instance, if we take Put Options on the S&P and/or Russell as an example:

 

SPY:

Current Price: $185.49

Dec 31 2014 – Put - Strike Price:$180 - Selling for $8.11, which is equivalent to 4.5% of the Strike Price. Not to mention that it is 2.9% out of the money.

 

IWM

Current Price: $114.29

Dec 31 2014 – Put - Strike Price: $110 - Selling for $6.83, which is equivalent to 6.2% of the Strike Price. Not to mention that it is 3.8% out of the money.

 

Am I missing something? Are there cheaper ways to purchase downside protection in the current market?

 

[Uccmal]

Hi Cevian,  I am only going to share experience with shorting markets, not advise. 

 

I have bought index puts on many occasions, enough times to know it doesn't work for me.  I consistently lose money with them, or sell way too early (2008).  The problem for me rests with when to sell, or more precisely: How do I estimate the value the market should be at, and therefore some kind of target price. 

 

I have come to the conclusion with index puts, and puts in general that I should raise my cash levels instead.  If I am starting to question the valuation of my stocks and the general markets this is the cheapest way to prepare for a correction.  I will use puts on key stocks at key times, such as year end to push off taxes into the following year. 

 

FFH provides the perfect example for me of the cost of holding cash versus using derivatives as downside protection.  I am not talking about then CDs but rather the total return swaps. 

 

[giofranchi]

I have come to the conclusion with index puts, and puts in general that I should raise my cash levels instead.  If I am starting to question the valuation of my stocks and the general markets this is the cheapest way to prepare for a correction.

 

+1

 

Gio

[writser]

Agreed. Always invert. Don't buy insurance, sell stuff.

[tombgrt]

Agreed. Always invert. Don't buy insurance, sell stuff.

 

Aren't you already inverting by not doing the obvious thing (selling a relatively cheap holding in an expensive market)? IMO "Invert, always invert" is overhyped and used whenever possible without really saying much.

 

[giofranchi]

Aren't you already inverting by not doing the obvious thing (selling a relatively cheap holding in an expensive market)?

 

Actually I keep buying cheap stuff: I have bought more LRE this morning, and I will buy more ALS at market open. But… I also increase my cash level! Simply because I have not used all the cash that’s coming in for my purchases. ;)

 

Gio

 

[SharperDingaan]

Couple of things learnt from hedging concentrated portfolios.....

 

Separate market risk from the Beta risks on your individual holdings. Adjust the Beta risks for near term expectations. If you anticipate a fall, you want just the high Beta risks sold/hedged, & only those where there are no near term events expected. You are doing a poor mans delta hedge.

 

For a single stock portfolio, the perfect hedge is a 50% sale & repurchase. Cash & flexibility, & net zero gain/loss. For concentrated portfolios it is maybe 25-30%, & comprised of a 100% sale of the unmitigated high beta risks. Cash on hand, & residual weightings remain the same.

 

If you sell calls on the portfolio for cash, you are assuming a short down-turn, & need BOTH the direction & duration to be right. If it goes longer than anticipated, sale & repurchase is usually the better option. By orders of magnitude.

 

Good luck to you.

 

SD

 

 

 

 

 

 

[gary17]

I believe there's a 30 day wait in canada before one can repurchase to register the "loss" for tax purposes....

[Guest wellmont]

interesting I think on at least 3 occasions buffett withstood 50% (temporary) declines in his net worth. the key was he knew it was temporary. Because he knew he owned things that were selling below IV at the same time increasing IV. he also understood that the declines meant he would be able to dramatically increase his NW in the future because he had cash on his balance sheet, and more cash coming in every day. So he always could buy when things were cheap.

[bmichaud]

Agreed. Always invert. Don't buy insurance, sell stuff.

 

Aren't you already inverting by not doing the obvious thing (selling a relatively cheap holding in an expensive market)? IMO "Invert, always invert" is overhyped and used whenever possible without really saying much.

 

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++1

 

 

[writser]

Agreed. Always invert. Don't buy insurance, sell stuff.

 

Aren't you already inverting by not doing the obvious thing (selling a relatively cheap holding in an expensive market)? IMO "Invert, always invert" is overhyped and used whenever possible without really saying much.

 

I thought it was appropriate: somebody is asking about purchasing downside protection but maybe could consider the inverse (selling upside participation) to achieve the same goal. But feel free to ignore the quote :)

[giofranchi]

So he always could buy when things were cheap.

 

Exactly! This is crucial! Make sure you always have cash when things are cheap. How… don’t ask me! ;)

 

Gio

[ukvalueinvestment]

I tend to agree that messing around with puts and other strategies is implicitly trying to time the market and is not value investing.  We all know it's impossibly to time the market correctly on a consistent basis.  It can get very expensive if you're constantly rolling contracts, and trying to monitor these positions detracts from the core activity of finding cheap investments.

 

I like what I read somewhere in another thread about Pabrai increasing his required return for incremental capital invested.  Put another way, your investing standards should go up the better you are doing.

 

When the inevitable fall comes you will be fine if a) you made good buying decisions in the first place (ie margin of safety) b) you bought liquid and cash generative assets that will enable you to reposition your portfolio and make incremental investments.

 

Basically, the standard I hold myself to at the moment is: "If you buy this, will you still be comfortable if the share price falls 50%?"

[lessthaniv]

how do you feel about owning something like RWM - Proshares, short Russell 2000? It's unlevered

one could argue this is value investing...

[ukvalueinvestment]

Is that some sort of inverse ETF?

 

Just how is that "investing"?

[giofranchi]

how do you feel about owning something like RWM - Proshares, short Russell 2000? It's unlevered

one could argue this is value investing...

 

I own it. ;)

 

Gio

[giofranchi]

Just how is that "investing"?

 

It is not. It is supposed to be insurance. I don’t like it much. But I guess a small percentage of a portfolio might be justified at these prices.

 

lessthaniv might have simply meant that what works for lessthaniv should work for muchmorethaniv too: that is regressiontoiv! ;D

 

Gio

 

[lessthaniv]

Is that some sort of inverse ETF?

 

Just how is that "investing"?

 

Yes, an unlevered, inverse ETF.

 

Value investing defined as being; exploiting the difference between market value and intrinsic value.

[giofranchi]

Value investing defined as being; exploiting the difference between market value and intrinsic value.

 

Yes! That's what I meant! ;)

 

Gio

[ukvalueinvestment]

I'm not convinced.  What if the market stays like this or higher, for years and years and years, fuelled by low interest rates?

 

You are owning something that produces no yield, and is basically an opportunity cost that stops you holding other cheap stuff that is out there.

[lessthaniv]

i'm using it as a hedge. i'm long a group of stocks but feeling that some markets are becoming extended. as you suggest, if markets are flat or growing - from the time of purchase this holding will be a drag against my other positions but netted, I would expect a positive outcome. if the market goes the other way, I will have hedge my downside some, and have a basket of cash to buy into my other names which will likely be down too. I should add, these are in tax-sheltered accounts.

[ukvalueinvestment]

Fair enough.

 

My personal view is that investing is hard enough that I should concentrate 100% on finding a few good individual investments - nothing more.  Fortunately, I think we can both do well.

[giofranchi]

My personal view is that investing is hard enough that I should concentrate 100% on finding a few good individual investments - nothing more.

 

I concentrate 80% on finding a few good individual investments and 20% on never running out of cash. ;)

 

Gio

 

[Orange]

 

Am I missing something? Are there cheaper ways to purchase downside protection in the current market?

 

 

You are missing the fact that buying a 180 strike put when SPY is trading at 186 is hardly insurance. Certainly, it is nothing like buying a credit default swap. A CDS is a bet on the total, utter collapse of something. You, on the other hand, are insuring against a mere 5% market decline. Of course that will be way more expensive. It's apples and oranges.

 

If you want to find anything resembling a 2008 style CDS, you must find a security you think will collapse, but also has cheap premiums. The VIX is low and the markets are way too complacent, so premiums in general are low. This is good. Now, go find a stock that will fall 50% or more if the markets/economy go south. Buy far OTM puts. Time value decay accelerates as expiration nears, so stay as far out as possible. E.g., Buy puts that expire in 2 years and roll every year (assuming you want to keep the hedge).

 

Until you find this, hedge by raising cash. These are just my opinions on the matter. Good luck.

 

[Cevian]

Thank you all for your replies. I appreciate that we are value investors and that this is what we should be focused on, however, part of value investing, in my opinion, is also looking for asymmetric bets. I don't think the discussion should really be about what to buy and what not to buy but "at what price?". Most everything has a price at which it becomes interesting.

 

For example, if I could buy downside insurance for say 0.5-1% to protect against a market downturn, I would definitely consider it and pay close attention. I would definitely pass if the rates were much higher than that, which is the case with the current SPY and IWM example.

 

What I find interesting though is that, when you read about some of the hedge fund history and successes over the past decade, there appears to have been cheap insurance protection available (via CDS or otherwise) at various times.

 

I guess my question is: is anyone seeing an opportunity for "cheap downside protection"? (Thanks for the RWM example which I will look into)