Risk Bubbles To The Surface: From The Nord Stream Sabotage, To The Near-Lehman Moment In Britain, Risk Is On The Rise.

Market Bounces Despite Increasing Risks

Despite the grim news this week, from the near-Lehman level crisis in Britain, to the sabotage of the Nord Stream pipelines in the Baltic,

Tucker Carlson's Monologue On The Foreign Policy Consequences Of The Breaching Of The Nordstream Pipelines, The Likelihood That They Were Sabotaged And Who May Be Responsible pic.twitter.com/92b2Z92khj

— The Columbia Bugle � (@ColumbiaBugle) September 28, 2022

To Stanley Druckenmiller’s prediction of fiscal doom,

"We're in deep trouble," says Stanley Druckenmiller on the nation's entitlement and debt crisis. #DeliveringAlpha pic.twitter.com/5Gydn3JfSj

— CNBC (@CNBC) September 28, 2022

Major market indexes nevertheless bounced on Wednesday. It might be prudent to take advantage of the next bounce day to hedge. Let’s look at a way of doing so below.

Setting Initial Conditions

For the purposes of this example, we’ll assume your portfolio is worth $500,000, and that it’s closely correlated with the SPDR S&P 500 Trust SPY. We’ll also assume you have enough diversification within it to protect against stock-specific risk, and that you can tolerate a decline of up to 20%. If you have a smaller risk tolerance, you can use the same approach entering a smaller decline threshold, Similarly, if you have a larger or smaller portfolio, you can adjust Step 1 below accordingly. If you have gold, bonds, or other asset classes in your portfolio, we’ll address that at the end. 

Hedging Stock Market Risk

Step 1

Divide the dollar value of your portfolio by the current price of SPY. For this example, we’ll use numbers as of Friday’s close, but obviously, you’ll use current data when you do it. SPY closed at $370.53 on Wednesday. Dividing $500,000 by $370.53 gets you 1,349 shares.

Step 2

Scan for the optimal, or least expensive, puts to protect against a >20% decline in your number of shares of SPY at the options expiration you want. We’ve selected the January 20th expiration below. It’s far enough out to give you some breathing room, and it’s not too expensive. 

This and the next screen capture are via the Portfolio Armor iPhone app.

As you can see above, the number of options contracts the algorithm presented was 13. Since each options contract covers 100 shares, what our algorithm does when you enter a number containing an odd lot like 1,349 is this: it slightly over-hedges the round lots (the 1,300 shares, in this case), so that your entire position, including those extra 49 shares, is protected against the drawdown you specified. 

Note the cost here: $7,696, or 1.54% of portfolio value. The app calculated that conservatively, using the ask price of the puts (in practice, you can often buy options at some price between the bid and ask prices).

Step 3

Round up the number of SPY shares to the nearest 100 and repeat step 2.

Note that, in this case, it was cheaper to hedge 1,400 shares using the second hedge, so you would go with that. 

Hedging Other Asset Classes

In our simplified example above, your portfolio was 100% stocks that were highly correlated with SPY. Let’s say your portfolio includes a broader range of asset classes: 40% diversified stocks, 20% tech stocks, 40% bonds. You could use the same approach as above using the Invesco QQQ Trust QQQ as the ticker for the tech stocks, the iShares 20+ Year Treasury Bond ETF TLT or the iShares iBoxx $ Investment Grade Corporate Bond ETF LQD for the bonds (depending if they’re Treasuries or corporates). So, in that case, you’d divide the dollar amount of your tech stocks by the current price of QQQ, etc.  ​