by Brandon Wendell, Online Trading Academy
Online Trading Academy Article of the Week
Many investors have expressed concern to me about “when”, and not “if” the stock markets will crash. The problem is that when I ask them what their plan is to protect their portfolio, they usually do not have one. This is silly. If you are certain that an event is most likely to happen that has the potential to decimate your wealth, why wouldn’t you do something to help prevent suffering the massive loss?
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Some claim that they believe their broker will look out for them. Did your broker predict the 2008 market crash? Most did not and many others were late in taking action until most of the damage had been done. Some investors reflect on the market’s recovery from 2009 and claim that they would have been fine when their stocks came back. Unfortunately, they do not realize that they wasted many years waiting to get back to break even, years where they could have been earning and compounding those gains.
It is up to you to decide how and when you will retire. If you do not know how to prepare, then become educated. The process is not difficult, it just takes an open mind, the willingness to learn, and a successful mentor and support system.
Most people plan for their retirement by contributing to a 401k or other company sponsored plan. There are several drawbacks to these plans. The high fees can create drag which reduces the amount of money you make. There are limited choices in these plans, usually several mutual funds. And you cannot profit when the markets move sideways or down.
Online Trading Academy’s ProActive Investor program teaches investors many different ways that they can save for their retirement in methods other than just a 401k. These methods can get you much higher returns than your simple company sponsored plan alone.
If you do have retirement investments, you need to protect them when the markets drop. It would be easy enough to sell them but 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 can be attained at a fraction of the margin cost. At the time of my writing this article, the SPY is trading at about $240 per share. 500 shares of SPY would cost $120,000. Comparatively, the overnight margin requirement for the one futures contract of the ES is only $4620.
To hedge your portfolio properly, you need to determine the Beta Weighting of it. 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.
When you total the portfolio, there is $61,841 invested. Adding the result of the individual Betas multiplied by the individual investments we have 93,855. 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.
In my next article, I will examine how to protect a 401k portfolio consisting of mutual funds. But why wait, you can learn the correct methods of trading and investing by visiting your local Online Trading Academy center today.
