by Brandon Wendell, Online Trading Academy
Online Trading Academy Article of the Week
A few weeks ago I started the discussion on protecting your retirement against a market crash or even a severe correction. We discussed the use of derivatives such as options and futures to hedge a market position. In this article, I will continue diving into strategies that could be used for protecting your money in case you have it tied up in a 401k or similar retirement account and are unable to withdraw the funds in a market drop.
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If you recall, the first thing you need to do to hedge is to determine the Beta Weighting of your portfolio. Most retirement plans consist of mutual funds and even mutual funds have a beta. This can usually be found on most financial websites.
Once you have found the individual betas for each mutual fund in the account, 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 1.26 and consists of 2550 shares. This means that the investor needs insurance for 3213 shares (1.26 x 2550). If they were to sell S&P 500 eMini futures, six contracts would provide enough insurance for the portfolio. The problem is that the margin requirement for each contract is $4620 so the insurance would cost $32,340 to insure a $44,000 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 price level of 2474 for the start of the hedge. You will also notice that I am using the March 2018 contract and options instead of the current September one. This is done for two reasons. First, you want to insure yourself for enough time and you must also be aware of the time decay of options. If you do not buy enough time, you will lose premium and may be forced to roll over your position which results in additional commissions.
This example would insure this portfolio from now until early 2018! Buying the puts would cost approximately $4625 for each S&P 500 eMini put option we want. Wait, isn’t this the same price as selling the futures? Yes it is, but if you are better versed in options trading and are able to determine both supply and demand levels with a high degree of accuracy, you can create a bear put spread position and greatly reduce the cost of the insurance.
This hedge can be 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. In our ProActive Investor course you can even learn Dynamic Portfolio Management and other strategies that can increase your chances of retiring how and when you want to. Come see what we can do to help you move out of the fear zone and achieve your goals as an investor.
