The current bull market that started in 2009 is the 3rd longest bull market in history. We’ve been in this state for 2,287 days (since March 6, 2009.) Moreover, during this period we haven’t seen a 10% correction for 968 days already (since August 4, 2011), which makes it the 5th longest period without a 10% correction. No wonder, many analysts and investors are getting nervous saying the market is overvalued and due for a pullback.
For example, Shiller P/E is at 27.28. Although it is way below its historical maximum of 44.19 right before the dot-com bubble burst, it is certainly pretty high. The other famous indicator, the Buffett indicator (a ratio of market capitalization over total GDP) now is at 124% and steadily approaches its historical maximum of 149%.
While many valuation metrics and some economic data indeed point out that the market maybe overvalued, we all have to remember what Keynes once said: markets can remain irrational longer than you can stay solvent. What does it mean? It means that the market still can go higher. It means that the market can go sideways and we will not see a 10% correction for another N days. While I personally have some concerns as well (in fact, I’ve been having them since the beginning of 2014), a key lesson that I learned from my past is to follow the trend and take any noise out of the process. Nevertheless, despite all the pleasures of an uptrend, a prudent investor should hope for the best but prepare for the worst.
There are basically three ways to be prepared for the worst:
- Go into cash
- Tighten your stops
- Hedge your positions
Going into cash is the easiest one to implement. You just sell all your positions and wait. Wait for a Fed rate hike, for a Grexit, for an oil recovery, or whatever event you wait for that may trigger a reverse in price. It can be very rewarding (consider cashing out in October 2007 and getting back 1.5 years later) or very costly (for example, cashing out during the rising market in 2011 or 2012 or 2013 or 2014 when many forecasters were predicting a correction.) However, going into cash heavily relies on predicting prices or future events, which I believe is not possible to do (at least on a constant basis.) Going into cash makes sense only when you can’t find a value.
Depending on your investment style or utilized investment strategy, using protective stops is almost always a wise idea. Tightening your stops allow to protect profits and avoid significant drawdowns in the account value. However, I will cover this topic in the future.
If you believe that the market still has some room to go but is concerned that the long-awaited correction may hit the market soon, the best way to protect your account is perhaps to hedge your positions. Below are seven ways investors can hedge their positions.
Please be aware, that hedging requires some knowledge and may not be appropriate for DIY investors. I will briefly outline all options without going into details. Also, I assume that the investor is long market ETF and not specific stock(s) (even though all the methods can be applied for stock positions as well.) Hedging is the area where your investment adviser can bring value and you should definitely ask him/her what is it exactly s/he is doing to protect your account from a potential market decline.
7 Ways to Hedge Your Portfolio
- Put options on an index. For example, investors can purchase put options on an S&P index and, hence, stay protected during negative markets. However, after the 1987 market crash all index options exhibit a phenomenon that is known as a negative skew. In other words, many investors want insurance in case of another market collapse and are willing to pay a higher price for the out-of-the-money puts as a hedge. That makes put options on indices expensive.
- Short futures on indices. For example, in order to protect long equity position, one may short futures on S&P index. A few advantages of using futures are high liquidity, low trading costs, and favorable tax treatment. Alternatively, one can construct a synthetic short futures position by purchasing an ATM put and selling an ATM call.
- Buy Call options on VIX Index. VIX index represents the expected market volatility over the next 30 days. It is constructed using the implied volatility of SPX options. VIX index has a negative correlation with S&P 500 market (-0.75), which means that when the market is falling, VIX index is usually rising, and vice versa. You cannot invest directly in VIX index and this is the main idea on why to use VIX derivatives for hedging purposes. To protect your positions, you can consider buying call options on VIX index. The advantage of VIX options is the ability to choose the exact strike you want to, plus customize the length of your position, for example, from one month and up to 2 years by utilizing LEAPS.
- Buy VIX futures. Using VIX futures for hedging purposes is perhaps one of the hardest things to do, especially for DIY investors. Why? Because VIX futures do not always follow the VIX index. The further away your futures expiration, the lower the correlation with the VIX index. However, the closer the expiration date, the relationship between the VIX index and futures is pretty straight. Usually, VIX futures are utilized to capture mispricing between futures and the underlying market by arbitrageurs or active traders. If you are confident that the market correction is right around the corner, you may want to try hedge your position by using the near-term VIX futures and keep them until expiration, where they should converge with the index.
- Buy VIX ETNs/ETFs. A more intuitive approach to hedge your long equity position is by using VIX ETNs or ETFs that are designed to provide exposure to the S&P 500 VIX Short-Term Futures Index, which is in turn designed to provide access to equity market volatility through the VIX index futures. As I mentioned in the previous item, VIX futures do not necessarily follow the VIX index. If you want to simulate the VIX index as close as possible, you need to stay short-term and keep up rolling your futures contracts over. Because it is a very time-consuming endeavor, you are better off investing in, for example, VXX ETN that will do all the work for you.
- Buy inverse equity ETFs. The main idea behind inverse ETFs is to grow in value when the market falls. Like with shorting futures approach, utilizing inverse ETFs allow investors to protect their equity position during a market decline. Consider SH ETF to hedge your position during a market decline.
- Create a fence strategy. This is a classic options hedging strategy that assumes holding a long equity position, short out-of-the-money call, and long out-of-the-money put. Basically, this is a synthetical bull vertical spread. When done correctly, the initial cash outlay is around zero, making it a very cheap way to protect your current position.
As you may have noticed, hedging your positions is generally not an easy thing do. It usually involves the use of derivatives and that alone may be a red flag for many investors. In addition, each method requires a constant monitoring, which makes it a very time-consuming work. However, despite all these difficulties, hedging is a must have instrument in the arsenal of an investor who takes investing seriously.