Insurance for Portfolio

[Hershey]

Please advise the best way to purchase insurance to protect against a 25% drop in a stock portfolio.  I have only read about doing this through Puts, and am curious if this is the only way.  Also, I want the term of insurance to expire as long into the future as possible.  Thanks in advance.

[gfp]

-Reduce market exposure (may not be desirable for tax reasons)

-Short a stock market index futures contract or ETF (example - S&P eMini or SPY exchange traded fund)

-Buy long-dated Puts on your index of choice (you can go out to December 2017 on SPX and SPY puts currently)

 

or perhaps buy something that you believe will rise in a down market - Fairfax for example might hold up better than the pack, but it is far from a perfect hedge...

[rb]

If you are looking to capture the upside while insuring for the downside, then by definition you are looking for a put option. Nothing else.

 

If you are looking for a relative value strategy because you think that your stock picking is superior then you would go long short. You can go long your picks and short the market (index) or long quality and short crap - more industry specific.

[innerscorecard]

What's the most efficient way for individuals to implement a long-short strategy, considering the cost of borrow on the stocks to be shorted as well as any other relevant factors?

 

Obviously the wisdom of such a strategy in the first place is another matter entirely, but I am curious about how it would be implemented.

[KinAlberta]

Read a few years of John Hussman's Weekly letters and look at his performance. The poor guy has been hedging for years now.  I think he takes fiduciary responsibility very seriously, but I doubt his fund's investors feel the same way.  Anyway, basically there's a downside to hedging - until suddenly there isn't.

[Hershey]

Thanks.    So far, it does not look like there is an affordable way to protect against significant downside.  I am not a fan of options or shorting generally, mostly because they do not make intuitive sense to me and are timing based, so I will probably not do anything. 

[ni-co]

Depends what you want your portfolio to insure against/how loosely your insurance has to be tied to the S&P500 for example. I ensured part of my portfolio very cheaply I think with buying calls on long term treasury ETFs. This is much cheaper than buying equity puts, momentarily. I bought incredibly cheap TLH (iShares 10-20 Year Treasury Bond ETF) calls expiring in September for ~4-5% implied vol.

 

As a general advice, it's much cheaper to buy calls on things that go up in a crash than buy puts on equities. Comparable puts on the SPY carry ~18% implied vol – 4x the price for what I regard as a similar kind of insurance.

[rb]

Depends what you want your portfolio to insure against/how loosely your insurance has to be tied to the S&P500 for example. I ensured part of my portfolio very cheaply I think with buying calls on long term treasury ETFs. This is much cheaper than buying equity puts, momentarily. I bought incredibly cheap TLH (iShares 10-20 Year Treasury Bond ETF) calls expiring in September for ~4-5% implied vol.

 

That's smart. I'll have to keep that one in mind. Have you thought about using the VIX derivatives? If markets crash VIX for sure will shoot up like crazy.

 

[ni-co]

Depends what you want your portfolio to insure against/how loosely your insurance has to be tied to the S&P500 for example. I ensured part of my portfolio very cheaply I think with buying calls on long term treasury ETFs. This is much cheaper than buying equity puts, momentarily. I bought incredibly cheap TLH (iShares 10-20 Year Treasury Bond ETF) calls expiring in September for ~4-5% implied vol.

 

That's smart. I'll have to keep that one in mind. Have you thought about using the VIX derivatives? If markets crash VIX for sure will shoot up like crazy.

 

Yes. That should also work – though it's a bit more loosely correlated, I guess, especially in a grindingly slow downturn you don't have any insurance. I've looked into the futures but not really that deeply. With options I'm long vol, too.

[ni-co]

Idea for the "enterprising investor": buy calls on treasury ETFs and sell puts on the S&P 500 – adult supervision is required  ;D

[CorpRaider]

1987 has just what you need.

[ni-co]

1987 has just what you need.

 

Yeah, true. It's not the same as SPY puts. There are scenarios where it wouldn't work – like, well 1987. I'd guess that a 1987 scenario is quite unlikely now, because inflation showing up is unlikely to be something that would crash the equity market where the main concern is deflation, even though it would mean higher interest rates. But you're right – you never know.

 

Also think about the fact that we're talking about options here and you're paying 4x the price for S&P puts. This gives you quite a bit of margin of safety in a "normal" crash. Of course this is not the same as keeping x% of your money in cash.

 

I had shorted equity futures as a hedge before (which worked quite well) but decided to use the low vol to my advantage instead. That's why I've been shifting my equity exposure as far as I could into call options with much less capital at risk and – roughly – the same upside. I try to cover the rest of the downside with said treasury calls and long term out of the money calls on GLD. But +50% of my portfolio is now cash (though I'm long and short some currencies).

[rb]

I don't exactly see how 1987 is directly relate to this. 1987 was caused by dynamic delta hedging of put options and the ppl that got burned were the ones who wrote put options as an income investment (markets never go down sort of thing). If you hold a put option or some other hedge for fundamental reasons it's a completely different thing.

[ni-co]

Yes, but, to be honest, I think CorpRaider was referring  more to my suggestion for the "enterprising investor" who'd get crushed in a 1987 scenario.

[rb]

Yes, but I think CorpRaider was referring  more to my suggestion for the "enterprising investor" who'd get crushed in a 1987 scenario.

Did rates go up in oct 1987?

[ni-co]

Not on the day of the crash. But 30 year bonds essentially didn't move and you lost quite a lot of money in the months before the crash. So, yes, a 1987 is not covered by this insurance.

[rb]

Not on the day of the crash. But 30 year bonds essentially didn't move and you lost quite a lot of money in the months before the crash. So, yes, a 1987 is not covered by this insurance.

Then I apologize, while I have a very good understanding of rats and their behavior I'm more of an equities guy and don't keep an encyclopedic knowledge of rates movement.

 

That being said I am of the opinion that we are more at risk of having 1987 type crashes since algos kind of rule the markets these days and those are all based on dynamic hedging. But if we invest on fundamentals I think we should be ok.

[thepupil]

Corp Raider was making a joke about the then popular "portfolio insurance" products that arguably exacerbated the 1987 crash. They were basically systematic stop loss orders that seemed great in theory but the more people that adopted the strategy the less effective it would become because the robots all wanted to sell at once. It is debatable whether or not portfolio insurance was the "cause"; other things like index arbitrage, a ruling in congress that busted a few merger arbs a few weeks prior, and other things have been blamed.

[CorpRaider]

Yeah, sorry was just making a dumb (old guy?) joke.  Didn't meant to be cryptic. 

[ni-co]

Yeah, sorry was just making a dumb (old guy?) joke.  Didn't meant to be cryptic.

 

Oops, sorry, obviously I didn't get it.  :-[

Anyway, 1987 fits perfectly as a criticism of this strategy.

[Patmo]

My two pennies for what they're worth, the best insurance against a 25% drop in portfolio would be to have the financial strength to ensure that it remains a temporary drop, eg. don't have to take any money out of your book whether to live, pay down leverage, or any other reason. Then it stops being a risk and becomes just variance.