After my article on portfolio protection was published, I was fortunate enough to meet with several students in our Online Trading Academy Austin center. One student was concerned about the status of his 401k. He had recently endured the pullback in the markets in September and October and wondered as many of you probably did if it was another 2008.
The student read my Portfolio Protection article and wanted to see if the strategy would work for his 401k which held mutual funds and not just individual stocks as I used as an example. I realized that this is a problem that many people face and figured it would make a great follow up to my earlier article.
If you recall, the first thing we need to do is to determine the Beta Weighting of the portfolio. Even mutual funds have a beta. This can usually be found on most financial websites.
Once you have found the individual betas, calculate the portfolio’s total beta using the method I mentioned previously. I have selected several mutual funds from different companies to create a hypothetical portfolio below.
As you can see, this portfolio’s beta is 1.34 and consists of 2700 shares. This means that the investor needs insurance for 3618 shares. If they were to sell S&P 500 eMini futures, seven contracts would provide insurance for the portfolio. The problem is that the margin requirement for each contract is $5060 so the insurance would cost $35,420 to insure a $41,000 portfolio. This hardly seems efficient.
Fortunately there are additional ways to trade the S&P futures that will offer a more cost efficient method with similar protections. I had previously mentioned that most investors will trade options to hedge a position. Specifically they will purchase puts on shares that they own. This works for individual stocks as they are optionable. Mutual funds do not have options available however.
Since we were planning to use the S&P 500 derivatives to hedge a portfolio, we can instead use the options on the futures. This will greatly reduce the cost of the insurance for our portfolio but still provide the same coverage.
Looking at the S&P 500 eMini’s options, I am using the current price level of 2034 for the start of the hedge. You will also notice that I am using the March 2015 contract and options instead of the current December one. This is because when you trade options, you must be aware of time decay and also want to have enough time for the position to cover your hedge. If you do not buy enough time, you will lose premium and also may be forced to roll over your position which results in additional commissions.
So the puts would cost approximately $64 for each eMini we want. This would be a total cost of $896, (14 x 64). Wait, why did I use 14 and not seven as I used before? Options traders know about Delta, the hedge ratio. I am using, “at the money put options,” which have a delta of -0.50. So for every 500 shares of the SPY I want, (the S&P 500 eMini futures contract equals 500 SPY), I need two put options.
This hedge is still less expensive than buying individual puts on stock, shorting the SPY, selling the ES (S&P 500 eMini), or simply holding on. As you can see there are several additional factors that you must be aware of. You need to know a little about options as you may want to buy a different put option due to pricing. You can also look to do the hedge in a retirement account such as an IRA so that there are different tax ramifications.
Even more important is knowing when to put on the hedge and when to remove it. You will need to know Online Trading Academy’s core strategy of market timing to learn when your portfolio is vulnerable and when to remove the hedge to let your portfolio grow. Come see what we can do to help you move out of the fear zone and become a successful investor.