Markus: With all this craziness going on in the markets, Mark and myself, want to talk about three ways you can hedge against a market crash to protect yourself against risk. We have a few portfolio hedging strategies to cover to minimize market risk when trading.
Buy Calls On VXX
The Fear Gauge
One of the first things that most investors and traders often say regarding portfolio hedging is that you can buy call options on the VIX volatility index to hedge your portfolio when trading during a market crash. The VIX volatility index is known as “the fear gauge” of the stock market, and it’s a volatility index. Its measures market volatility.
Mark: This volatility index (VIX), or “the fear gauge” is based on the S&P 500 option premium, essentially going one month out. So when premiums increase, you have more fear in the market. This is because people believe there’s going to be more movement in the market with higher market volatility, and that sends the VIX higher, implying more risk.
There’s actually a VIX futures contract, the VXX. This is a stock or ETF that tracks the VIX itself. This is something that could be traded both as an ETF or an option contract.
Markus: Right, and we’re seeing this today (February 10th at the time of this writing) as the market is going down as well as the market prices of stocks.
The Nasdaq is down 2.3 percent. The VIX is up 21 percent, and the VXX it’s up 10 percent.
The idea for this portfolio hedging strategy is to buy calls whenever it is jumping like this, The Nasdaq is going down as well as the S&P, and the Dow. So this is one of the strategies that you can do.
Let’s take a look to see if this strategy makes sense, and for whom it makes sense.
Let’s take a look at an options chain for VXX. The question is until when do you want to have your portfolio hedged? We can go ahead and choose 3/18, which is just a little bit over a month from now when the option expires (at the time of this writing on Feb. 10th, 2022).
As we look at call options we decide at what level the VIX has to jump above to protect ourselves. In this case, we’re going to go with 22, and right now the last traded price would be $2.38.
For this example, we buy 22 strike price calls expiring 3/18. So this would be a little bit over a month from now for $2.40. Now the stocks are trading in 100 packs, so this means that we would have to spend about $240 total for 100 stocks. The idea is if the VIX goes up and spikes, we are making money on these calls.
What Are Some Disadvantages?
Let’s just assume that you have a $100,000 stock portfolio that you want to protect. Now the question is, how many of these VIX calls should you buy to protect your portfolio in a market decline? The number of contracts that you need to buy or sell can be difficult to determine.
Mark: Even today (February 10, 2022) it feels like the market is really falling. They’re pulling back. But you look at the spike previously and we’re nowhere near those highs, so even if the markets are falling, it could be that the VIX doesn’t spike as much as you expect. Also, when you go to buy them because the market is falling, you’re going to overpay.
Markus: Something else to keep in mind for this strategy, if we look back at the VIX, these spikes happen quickly and then they disappear. Timing is very crucial. In order to cash in, you almost need to watch the market on a daily basis
The idea of a hedge is that you don’t want to worry about the markets for the next two to four weeks because you’re going on a vacation, or you have other things to do. So basically needing to babysit your options to cash in is a huge disadvantage.
Mark: And that’s a tricky thing, because when you get that spike of the current price, yes, you might be able to profit from the spike, but then you’re no longer hedged. So instead, you’re paying this price for a kind of pseudo insurance. Then if the current price pulls back, it just becomes expensive because you bought those calls.
Markus: At what stock price do you sell them? When they jump to $27? $28? And what happens if the market crashes like it did in May 2020? We are currently seeing spikes around 30, but when it goes up to around $70-$80, suddenly you’re no longer protected.
Obviously, this is not very good even though many people think it’s a good idea. I think this is the absolute worst way to hedge a portfolio.
Mark: Yeah, it’s my least favorite. I feel that the VIX actually is more efficient than people think, it’s priced efficiently. This is why I really have a hard time trading volatility products.
Buy Put Options On The SPY
Markus: The next way to hedge your portfolio would be to buy a put option, or put options, on a contract like the SPY, for example.
The SPY is also an ETF (exchange-traded funds) that kind of mirrors the market index, the S&P 500 index. The advantage is it’s not as expensive as the S&P 500 index. It’s approximately a tenth of this.
Some people like to buy put options to get some downside protection in the market to hedge against potential losses.
For this, let’s look at getting some protection at the $440 price level.
The plan is to buy puts on the SPY at the 440 strike price, expiring 3/18, about a month from now. Now let’s figure out how much this will cost.
How Much Will This Cost?
Looking at an expiration date of 3/18 for the puts at the 440 strike price, we have a last traded price here of about $9 per put option. This sounds fairly expensive.
What Are The Advantages?
Let’s talk about the advantages first. It is fairly easy to calculate how many SPX options contracts we need to protect our $100,000 portfolio. If we would trade two option contracts with this, we have $88,000 protected. That’s not bad at all.
What Are The Disadvantages?
The disadvantage is that this is pretty expensive for insurance. But why is this so expensive?
We need to buy two 440 puts for $900 each, so the cost of this hedge is $1,800 dollars. This also means that to the downside protection, your break-even, is actually $9 lower here than the $440.
This means that right now the SPY has to move $9 higher for you to actually make money. This is important to understand.
Mark: The idea here is if you have a portfolio that is loosely tracking the S&P 500, it is basically mimicking the overall market. The S&P 500 is a good proxy for the U.S. markets. When you buy those puts, they’re expensive because the market has dropped a little bit, which is why you’re paying a lot.
For you to offset that hedge, that portfolio would need to go up to offset that expense. This means for you to really be making money, it needs to drop some.
Markus: If it doesn’t drop below $431, you’re not making any money on the puts. That doesn’t sound very efficient. So far we’re not off to a good start for this method, but I think it is important that you understand your different options.
Mark: Here’s the thing. This would be the cheapest option, in my opinion, to try and get insurance, but I think that the trickiest thing here is we just went out a month. If we went out for six months, it’s going to be way more expensive.
Think of all the times when the market isn’t falling. If you’re trying to hedge yourself, and you’re just paying that $1,800, all of a sudden you’re out $10,000 which is 10 percent.
What Is A Hedge
Markus: Before we go to the third thing, I think it also might make sense to look up what is the definition of a hedge? We’re not talking about protecting yourself, we’re talking about hedging yourself.
“A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.” – Investopedia
Now we’re getting somewhere. Let’s talk about the third possibility.
Buy An Inverse ETF
What Is An Inverse ETF?
This is to buy an inverse ETF to hedge against a market crash. What does this mean Mark?
Mark: You have ETFs that mimic the different market indices. You have an ETF that tracks the Dow index, the Nasdaq index, the S&P 500 index, and the Russell index. Those are going to be ETFs that move with the index just like the SPY.
But an inverse ETF actually moves in the opposite direction. So if the S&P 500 is going up, the inverse ETF is going down. You’re losing money if you’ve bought shares of the ETF.
But if the S&P 500 is falling, the inverse ETF is actually making money and increasing if you’ve bought shares. So you break even for either of these market conditions. Same with The Dow Jones. If The Dow Jones index goes up, the inverse ETF goes down and visa-versa.
Markus: Now let’s talk about the Inverse ETFs.
Let’s take a look at the one for the Dow Jones Industrial Average. Let’s just say you have a stock portfolio that mainly consists of value stocks that you typically find in the Dow Jones Index. What will be possible solutions here, Mark?
Mark: The ticker is DOG. This is going to move in the exact opposite of the Dow Jones Index.
If you look at the percent move, I think that’s the most revealing because with these inverse ETFs, there are some management fees and they’re balancing it daily.
One warning here, I would not do this for a long-term trade because it’s not going to mimic it perfectly long-term. For a short-term trade, it can be a great hedge.
Markus: Right, exactly. What if you have a portfolio that kind of mimics the S&P 500 index?
Mark: The inverse ETF would be SH.
Markus: Let’s take a very quick look at this.
If we look at the S&P 500 today, it’s down 2.18 percent, but SH is up exactly 2.18 eight percent. It doesn’t get any better. So let’s also talk about the Nasdaq.
Mark: For the Nasdaq, it would be PSQ.
The disadvantage of Inverse ETFs
Markus: Here is the problem. The disadvantage of this is, if you buy these, you have to tie up a lot of buying power. If you have a $100,000 portfolio and you want to protect yourself, you have to buy $100,000 worth of DOG, SH, or PSQ.
You might not have this buying power in cash in your portfolio and may actually tap into margin to do this. You may not be able to do this if you only have a cash account.
How Should You Hedge Your Portfolio Against A Stock Market Crash?
What would be, in your opinion, the best way to Hedge Against A Market Crash?
Mark: This would be what’s known as a leveraged ETF, and in this case, it would be a leveraged inverse ETF.
You might have heard us say we do not like to trade these with The Wheel. That’s for a reason. This is because they’re magnifying gains and losses.
But for a hedge, it actually is a useful tool for someone that doesn’t want to close positions but wants to manage their downside risk if something’s going on short-term.
Markus: Let’s take a look at some of those. What would be a leveraged one for the Dow?
DXD & SDOW
Mark: So two times the movement in the Dow would be the DXD, and then three times the movement would be SDOW.
Markus: Let’s take a look at the other ones really quick. And then we’ll tell you the advantages and disadvantages of this approach.
SDS & SPXU
Mark: The 2x for the S&P is SDS and the 3x is SPXU.
QUID & SQQQ
Markus: For the Nasdaq, if you have an entire portfolio that consists of value stocks or tech stocks?
Mark: For the Nasdaq, it’s QUID for 2x, and it’s SQQQ for the 3x.
Why This Make Sense
Markus: If you take two to three times leverage, especially three times, you basically only need a third of the buying power because it moves three times as much. You get more value out of this strategy because of this. This is a great way to hedge against a market crash.
Mark: If you have a portfolio that’s a little more value-oriented and you’re looking at your portfolio and you see that when you have up days, it’s really mimicking the movement in the Dow, then this is where you can buy shares in $33,000 worth instead of $100,000.
You’re going to get a real nice inverse move making money on the SDOW while you’re losing money on your portfolio, but hedging and balancing it out.
Markus: Here with the Leverage Inverse ETF, the advantage is it requires only one-third of the buying power. Another advantage is that you can protect your whole portfolio.
There’s no guessing. Because let’s say that you want to protect it with the SDOW and you have a $100,000 portfolio, then you just take the $100,000, divided by three because you move three times as much.
So it’s $33,333, and divide it by the current stock price, $28.24, and you see that you need to buy exactly 1,180. This way you have exact one-to-one protection. So this, I think, is a huge advantage.
But let’s talk about the “disadvantage.”
It is a full hedge meaning that if the Dow moves higher, the SDOW moves lower and you lose money on the SDOW while you’re making money on the Dow. It’s not really protection, but a full hedge against a market crash.
When does a full hedge make sense?
Let’s say you have some exposure to the stock market. For the next few days or weeks, you know that you cannot look at the stock market at all. You want to avoid a market crash and not get caught on the bad side.
You want to make sure that your portfolio’s value stays exactly where it is right now. That’s when a full hedge makes sense.
That’s not really a disadvantage, it’s an advantage. Easy to put on and off. And other than with options that we have earlier, you don’t have to worry about a timeframe.
You can do this for a day. You can do this for three to five days. It doesn’t really matter, it doesn’t require a timeframe.
Mark: And there could be some issues with longer-term timeframes. But there’d be no point to hedge your portfolio for six months. It wouldn’t make any sense to do this long-term.
Portfolio Hedging Strategies Summary
Markus: You need to understand that there are two things you need to know to hedge against a market crash.
There’s protection from a crash.
This is where, for example, you buy calls on the VIX, or buy puts on the SPY, and you’re worried about a market crash. You can put these trades on and sort of babysit them.
But if you want to best hedge your portfolio, meaning that you’re removing all the risks, both to the upside and the downside, then buying an inverse ETF and buying leveraged inverse ETFs, this might be the best thing that you can do to fully protect yourself for many investors. You will get the most value out of this strategy.
So now you know three ways to hedge against a market crash.