Stocks

Portfolio Protection

BrandonWendell
Brandon Wendell
Instructor, CMT

With the recent rise in volatility, there has been a lot of talk about a potential equity market crash.  Many investors are nervous about “when,” not “if” this crash will occur and are looking for some protection for their stock portfolios.  Many stocks pay dividends that the investors do not want to relinquish even during a crash.  Another reason for holding on to a stock position is to avoid tax ramifications on profitable sales of securities.

The most common protection that traders/investors seek is to buy puts on stocks they are holding.  The value of the put will increase as the price of the underlying stock decreases thus covering the losses in the stock position.  This is easy but also very expensive as you will have to pay a premium for every put you buy for every stock that you insure.

Fortunately there is a less expensive way to protect a portfolio. You can use the index futures markets as a hedge for your stock holdings.  Selling a future is easy if you know how they work and selling futures is also allowed in certain IRA accounts.

Before you go out and sell the ES (the S&P 500 E-Mini futures Contract), you need to know how many contracts you need to hedge your account.  The ES is the equivalent of trading 500 shares of the SPY but at a fraction of the margin cost.  At the time of my writing this article, the SPY is trading at about $198 per share.  500 shares would cost $97,500.  Comparatively, the overnight margin requirement for the ES is only $5060.

You need to analyze your portfolio and determine the Beta Weighting.  Beta is a measure of volatility versus the S&P 500 Index.  The index has a Beta of one.  If your stock’s Beta is 1.5, then it is 50% more volatile than the index.  On average, (not every day), when the index moves one percent, your stock should move about one and a half percent in the same direction.

There are several easy steps to Beta Weight your portfolio:

First, you can multiply the amount you have invested in each stock by the Beta of that stock.  Let’s take the sample portfolio below.

sample portfolio

When you total the portfolio there is $61,841 invested.  Adding the result of the individual Betas multiplied by the individual investments we have 93855.  Dividing that by the total amount invested gives us a Beta Weight of 1.51.  This portfolio is 51% more volatile than the S&P 500.  When the market moves in a particular direction, this portfolio should move 1 ½ times faster in the same direction.

Using your analysis of the S&P Index, you could determine how much you expect the markets to fall to their demand.  When you figure out the expected return, you could sell futures contracts to cover your losses in your stocks.  In the sample portfolio, the 1600 shares have a 1.51 beta.  To cover the potential losses, the investor would sell five S&P 500 eMini contracts to be market neutral, (1600 shares x 1.51 = 2400 and each eMini = 500 SPY shares).

There is a lot more to this, you need to know how to find the proper supply and demand zones and to measure your beta protection properly.  Sometimes it may be better to do an option position versus a future position to protect a stock holding.  Come learn the correct methods of trading and investing by visiting your local Online Trading Academy center today.

Brandon Wendell

bwendell@tradingacademy.com

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.