I have to write this because major media outlets, like CNBC, come out with these “awesome” (sarcasm detected?) click bait articles talking about protecting your 401(k) when the market has sudden spikes in volatility.  Click on the link if you feel inclined, but it sucks and doesn’t deserve any more hits than it has received.  In a nutshell, it’s a couple advisors with advice to wait out the storm, buy defensive stocks like consumer staples, buy into dividend paying companies, diversify, load up on gold, or my “favorite”- use limit orders.  Really?  Get the fuck out of here.  I guess that’s the ground breaking writing you get hiring a journalist, and get some advisors just trying to get their name on a “major” business network so they can impress clients.  Really, any washed up Ed Jones rep can tell you that crap.  None of that crap is useful in actually protecting your investments.

SHOTS FIRED!! (and I’m not talking about Financially Independent Retired Early this time)

So what would I say if interviewed about protecting your portfolio?

On a Friday where the S&P500 was down over 3.5% and most other major foreign benchmarks down much worse, wouldn’t you like it if your portfolio did absolutely nothing? Sure you would.  Then buy into protective puts for your portfolio with a respective controlling value.

What does that mean?  We’ll get to that in a bit.  But first lets use an analogy most people are familiar with when it comes to protecting an asset.  Homeowners insurance.  For most people, their home is their biggest asset (you know not to do this because you read my site, right?).  If their home burns down and they don’t have insurance, that person has to go out and buy (most likely take out a mortgage) and replace their home.  So let’s say that person owns a home that cost them $200k.  House burns down, no insurance, they have to go out and buy a replacement home on the marketplace.  Pretty expensive proposition.  This person has basically chosen to self insure their home and takes on the risk.  If nothing ever happens to the house, great.  If a catastrophe happens, you’re screwed.

Now let’s change it up a little and say that person has homeowners insurance.  The $200k house burns down, the insurance company sees that their home is rebuilt, puts them up in temporary housing and covers that cost.  The homeowner is out their premiums they paid and any deductible.  A whole hell of a lot less expensive to the homeowner.  The owner has essentially transferred the risk to the insurance company.

The same principals apply to life insurance in regards to income replacement.

Now lets circle back to protecting your investments

For purposes of this article, we are using the assumption that an investor is long their stock positions or other asset holdings (if you were short entering into Friday, congrats) and also unleveraged (not on margin), and we are not looking at transaction cost or taxes to keep things simple.

The first thing to understand is the profit and loss profile of owning a stock long.  Buying into stock, the profit is theoretically unlimited.  Let’s say you buy into 100 shares of a stock at $40 ($4000 initial outlay), if the price of the stock rises to $70, you have made a profit of $3000 ($7000-4000).  Profits are therefore unlimited as the price rises to infinity.

Lets say the stock price goes south.  You bought 100 shares at $40 (initial outlay $4000).  If the price of the stock goes south to say $10, you have a loss of $3000 ($4000-1000).  Losses of long stock ownership are however limited.  If the price goes to $0, you have a max loss of $4000 (0-4000).

Get it, got it, good.

Graphically drawn out the profit and loss diagram would look like this (represented by the red up diagonally sloping line):

Now for the Secret Sauce

Buying Put Options on your portfolio.  A put option gives the owner the right (but not an obligation) to sell a specified stock, at a specified time, at a specified price, all in exchange for a small premium (think about the homeowners insurance example above).  Buying a put on a stock you own is a way to provide protection from a major fall in the share price.

Looking at the above diagram (this time the blue line), lets say you buy an at the money (40) put option for a total premium of $200($2×100, an option contract is for 100 shares) against your $40 ($4000 outlay) stock position.  The purchase of the Put Options means your breakeven point on your positions is now $42 per share  ($40+2).  If the stock price never drops you wasted $200 on buying the Put Option.

However, lets say the stock absolutely goes down the shitter (this past Friday).  Lets say the stock drops to $35.  Owning the stock outright alone, you would have a $500 loss (4000-3500) or a 12.5% loss.

If you owned the at the money put option (strike price 40), the value of the Put would rise from $2 up to theoretically $7. Representing a gain of $500 ($700-200, don’t forget to multiply your option premium by 100) or a 250% gain.

When you combine the 2 positions above (long stock and the long put), your total loss/gain for the day would be $0. Not bad considering that piece of mind only cost you $200.  Even if the stock price goes to $0, the value of the Put options will rise to $40 (give or take for some time decay).

Graphically drawn out, a protective put strategy looks like this:

Where you max loss potential is only $200, breakeven is $42, and max profit is theoretically unlimited.

How do you apply this to an entire portfolio

Lets say you have a diversified portfolio of stocks (or even mutual funds or ETFs).  Lets also say the value of the portfolio is $1million.  Regardless of you holding a portfolio of stocks, some fancy active managed mutual fund, or an index fund or etf, there is something called coefficient of determination (r squared).

In plan English, it says that the return of a portfolio is to some degree tied to the performance of the overall market (you can find r squared on Morningstar), mathematically represented from 0 to 1.  What you will find when looking at most active funds, is a very high r squared.  Basically, the return of most active managed funds has a very high correlation and dependence to what the financial markets are doing.  Index funds will have an r squared of near 1 (rounding error, imperfect benchmarking prevents a perfectly exact correlation from happening).  I’m not even ashamed to admit, my own individual stock portfolio has a high correlation and r square to the US markets.  These are just facts people.  We all live in the same investment sandbox and build castles out of the same sand, with slight variations in the design of the castle.

Lets pick on American Funds Growth Fund of America (AGTHX), one of the most pushed funds because of the commission of 5.75%.  It has a 10 year r squared of 93.47, meaning most returns have come from the market movement.  Any deviation from the benchmark performance that can be attributed to smart managers is just 6.53.  The fund is a primarily US large cap fund with some foreign exposure, in total consisting of 400 freaking holdings inside the mutual fund (way more holdings than I care to hold, around 40).  If you had $1million invested in this fund and wanted to really hedge yourself  from something like Friday, all you would have to simply do is purchase Put options on either the S&P500 or Russell 1000.  While not a perfect hedge (perfect hedges are like the easter bunny anyways, they don’t exist), it does give you significantly correlated protection.

Example:  You had $1million in AGTHX as of Thursday closing.  It closed down 4.08% Friday, meaning your account is valued at $959,200 (ignoring expense fees charged).  Ouch.

To hedge, on Thursday you could have bought Put options on the S&P500 (using the ETF SPY June weekly because of the smaller spread) with a strike price of 210 (basically at the money) for $2.04.  You would need to purchase 48 contracts at the 210 strike to create this hedge.  (To come up with the # of contracts take the prior day value of $1million divided by the SPY price of $210.81, you get the shares, and I just round up and purchase the corresponding # of put contracts). Your outlay for the Put Options would be $9792. (You could also use the July Puts as well, which may be a better trade, since I think some more fallout should occur early next week).  That $9792 spent is used to protect your $1million.  We knew the Brexit vote was coming and the last few weeks the media and analyst have been swinging back and forth, so lots of uncertainty, but for some reason everything leaned heavily towards no exit this past week according to analyst.  This actually helped making insurance for portfolios cheaper.

So how would this trade play out in protecting your portfolio:

You have a loss on the AGHTX holding of -$40,800.

Your PUT options profit is  +$27,408 [{(7.75-2.04)*100}*48]

Net difference of loss of -$13,392 or a one day loss of -1.33% hedged vs a loss of $40,800 or -4.08% unhedged for the day

Not a bad one day difference

You exit the trade by selling the put options before market close Friday, do nothing to your mutual fund position.

So why wasn’t it a perfect hedge.  Like I mentioned above, perfect hedges don’t really exist.  Bid/Ask spreads, non 100% perfectly correlated assets (in this example, AGHTX underperformed the S&P500 by almost 1/2 percent in 1 day), and also in the real world taxes and transaction cost come into play.  If you were in the Vanguard 500 or SPY etf, the hedge would work out even better, but still not perfect.  I just wanted to show how it can be done for money you have tied in your 401(k) or brokerage account (to make the hedge happen, the options trade would have to take place in a brokerage account even if your money is in a 401(k)).

If all your money is in a small cap investment, you would probably use the IWM eft options.  All international stock fund, something like the options for EFA.  You basically have to find the best correlated benchmark, look for the EFT with the smallest bid/ask spread and work your hedge from there.  If you have mutual funds spread out across a few different asset classes, you may have to use a combination of options from different ETFs.

Personally for me these days, I’m just an S&P500 hedge kind of guy for my portfolio.  I think my days of small cap are behind me (for now).

So there you have it, a real way to actually protect your portfolio from volatility vs the lame crap that comes from the media, which does nothing to actually protect you:  The Protective Put and applying it to your portfolio.  These types of trades are useful around large known yetuncertain events.  Think about when congress couldn’t agree on a budget a few years back and a deadline was faced for government shut down.  If you know the date an event is going to trigger, then you know there will probably be some volatility surrounding that target date and can take out some insurance for that event.  It’s the unknown events, like a 9/11, that you don’t see coming that are impossible to hedge against (unless you’re lucky).  But basically a protective put is used to limit downside risk (i.e. losing a lot of money) on you position or portfolio.

People in the States are so happy to insure everything else in there life (burial insurance anyone?), but ignore insuring what should be their biggest asset, their finances.

Learn this shit, it’s important.  There are even ways to cover the cost of buying the puts, by shorting some calls against your position.  This would lower the $9792 entry fee for insuring your portfolio, but that is a topic for another day.  Mind blown yet?

Edit: 6/26.  A question I was emailed:  Why don’t advisors do this for customers?

Answer: There are a few reasons.  The main reason: Most of them don’t know anything about this stuff.  They take a series 7 test that includes options, but most of them just take a class to learn how to pass the exam, not actually learn this material.  I used to have a 1200 page book sitting at my desk.  When someone would come by asking questions on the subject matter, I tossed them the book and said the answer is somewhere in there.  It was a dick move on my part, but my time is worth something, so I can’t just hand out info.

Another reason is compliance.  Compliance departments for securities firms view options as ultra high risk for only the insane.  Yes, you can do speculative trades with options, but there are super low risk trades you can do as well.  Hell, there is one trade you can do that gets you into a stock at lower than market prices.  Unfortunately this trickles up to the industry regulators themselves, FINRA and the SEC.  Those guys are more likely to be looking at porn at work than actually doing things to protect investors.  The link is safe, I can’t make this stuff up.

Funny Video of dude pulling up porn around the 56 second marker (background on the left):

Another reason, just read that CNBC article, those guys basically say the same thing your advisor will tell you “just ride it out”.  They don’t care about your money.  They got paid when you handed over your money or they make money in annual advisory fees, regardless of your account going up or down.  So, if you aren’t handing over new money, they could give a fuck about you.  Really, they only want to keep you there to collect their 12b-1 fees or advisor fees.

So, unfortunately the industry will not change.  There is no motivation for it to change.

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