Our Seat Belts.
In our last article – Proactive Risk Management – we narrowed our Risk Management tactics down to 5 choices, most of which turn out to be executable.
Seatbelt 1: Short the Index. This is easy to do (there are many Short ETFs in the market) and this would hedge the downside if the market crashes. But what if the market keeps going up? Shorting the Index caps the upside too. That’s the problem. I want a hedge that doesn’t take away from my upside. This tactic isn’t really different from timing the market.
Seatbelt 2: The VIX Index. This is an exaggerated version of Seatbelt #1. I’ll discuss the VIX in detail below. For now, it’s important to know that the VIX is very highly negatively correlated with the broader markets, especially the S&P 500. That’s why it’s an attractive choice for a hedge. But it has the same problem as shorting the market – it’ll also be negatively correlated with the market on the upside. And it’s even more exaggerated – it behaves like a leveraged Short. You’ll see why in the VIX section below.
Seatbelt 3: Call Option on the VIX. To get around the problem of capping the upside, one could think of a Call Option on the VIX. This would give us the right (but not the obligation) to buy the VIX at a prespecified price in the future. Since the VIX increases sharply when the market crashes (remember it’s highly negatively correlated), it makes sense to participate in that VIX upside. And if the market appreciates significantly, which means the VIX level dips significantly, then we don’t exercise the option, and our loss from the trade is limited to just the price of the Option. It’s all good, in theory. But it’s hard for most of us regular investors to buy options on the VIX. So, because executability is a big priority at The Buylyst, I’ll leave this seatbelt out of the conversation.
Seatbelt 4: Put Options on single stocks. In Proactive Risk Management we identified the main “Risk Culprits” that contributed most to the portfolio’s Beta and to its Expected Shortfall. We could buy Put Options – which gives us the right to sell the stocks at prespecified prices in the future (but not the obligation) – for the main culprits. This is a logical move, but it doesn’t quite solve the “Beta effect” of a crashing market. More on this later.
Seatbelt 5: Put Option on the S&P 500. This is the ideal option (pun intended). This gives us the right (not the obligation) to sell the S&P 500 at a prespecified price at some point in the future. If the market crashes beyond this prespecified price, we’d exercise the option and collect a profit from the trade. This profit would offset (partially or fully) the losses that the portfolio will suffer because of panic and fear in the market. However, if the market continues on its upward trajectory, then we don’t exercise the option. Then our portfolio (hopefully) outperforms the giddy market anyway.
With all these seatbelts, the question is, “how much does it cost me to put this hedge on my portfolio?”. It becomes a question of Probability. You ask yourself, “what are the chances that the market will go through a major correction in the next few months?”. Based on this probability, you can back into a reasonable cost of buying a hedge against that correction. For example, if you’re 100% certain that the market will crash in the next few months, you’d pay a lot to buy that hedge. If you think there is a 1% chance, you wouldn’t pay as much. Big brokerage houses and hedge funds hire teams of rocket scientists to calculate these probabilities and prices for derivatives. I did this type of stuff for a while at a hedge fund. Don’t worry, we won’t. We’ll rely on basic math and common sense instead. We’ll figure it out.
Over the next few sections, I’ll discuss the VIX, Single-Stock Options, and the Index Option seatbelts. You’ll be a Risk Management Pro by the end of this article.