Are We in a Bubble? How to Hedge Your Portfolio Against Steep Sell-offs

Financial bubbles and bursts are difficult to spot and time.

Professor Robert J. Shiller’s chart of historical S&P 500 price to earnings ratios is a yardstick for U.S. stock market valuations, which are currently at very high historical levels.

Below I outline tools that can help reduce portfolio risk.

Some preliminary steps

  • Organize and declutter your portfolio. List holdings and determine long term investment goals.
  • Reduce appreciated and undesired positions.
  • Identify and reduce the riskiest positions. Looking at historical price moves during turbulent periods will help size potential losses in a downturn.
  • Address other risky elements such as margin, oversized positions, and near-term economic needs. Seek professional help if needed.
  • Picture an ideal, balanced portfolio. Size allocations to risks you can tolerate. Revisit periodically, making and implementing plans each time.

Five option strategies to reduce risk

1. Protective puts

A long asset position combined with a long put. It is a simple and effective way to protect assets against downward moves. Until the put expires, no risk remains below the strike.

The main drawback is the option premium cost. Usually it’s a poor index strategy, as out of the money low strike index puts have relatively expensive premiums.

2. Collars

A higher strike covered call can be used in combination with a protective put, with the same expiration. The resulting strategy is well suited for reducing volatility of individual stocks. Payouts can be attractive for growth and technology stocks like Tesla (TSLA) and Amazon (AMZN), where high strike calls command higher prices than low strike puts.

3. Index bear put spreads

Stock indexes are “skewed” towards lower strikes, which command higher relative value premiums. Index skews can be exploited by selling low strike options, while buying higher strike options.

As an example, use a SPDR S&P 500 ETF Trust (SPY) three month out of the money puts, struck 10% below the current price of SPY cost 4.25% of the ETF. If struck 20% out of the money, same expiration puts cost 2%. Thus, a 10% to 20% three-month bear put spread costs 2.25% of the notional. A put spread with the same strikes and a year expiration costs 2.5%.  The maximum payout of the strategy is 10%.

4. Haven assets bull call spreads

Haven assets rally when risky assets sell off. Yen, gold, and long-dated U.S. Treasuries are considered as havens.

The asset class low yield favors using options to add exposure, minimizing the cash used.

Gold can be traded via SPDR Gold Shares ETF (GLD). GLD options have relative high premiums for high strike calls, compared to lower strikes.

Bull call spreads are constructed buying a call, and simultaneously selling a higher strike call. Both options expire on the same date.

A one year out-of-the-money call, struck 10% above the current GLD price costs 5.5% of the ETF price. A GLD out-of-the-money call for the same expiration struck 20% out of the money costs 3.5%. Thus, a 10% to 20% GLD out of the money bull call spread costs 2% of the current gold price. The maximum payout of the strategy is 10%. 

Similar strategies can be constructed for iShares 20+ Year Treasury Bond ETF (TLT). Gold is a better hedge against inflation than treasuries.   

5. Covered calls

A long position in an asset combined with a short call option on the same asset.

Resulting positions remain mostly unchanged in upward price moves. In downward moves, losses are partially offset by the option premium. Main drawbacks of the strategy are the limited upside and unprotected potential for depreciation below the strike. 

A good choice for highly volatile stocks. They also release cash from existing positions and lower their cost basis.

Short term at the money covered calls collect more premium than longer term ones. At the money three-month premiums are about half of those for same strike one-year options.

Low strike options on indexes also command high relative value premiums. A year call struck 20% below the current price of the index for the iShares Russell 2000 ETF (IWM) costs 24% of the price of the index, removing risk above the strike while pocketing the premium and preserving additional income from dividends.

Disclosure: I hold SPY and related option positions in a net long.

Recommended Articles

8 Unconventional and Fun Ways to Make Extra Money

The number one formula for making money is that there is no formula. In fact, if you are willing to move away from the traditional path to earn money you

Science Says the Perfect Female Body Should Look Like This

Everyone has their own opinion of what the female body should look like. Society and the media often exhibit women that are thin as the ideal womanly figure. This causes

Americans Are More Afraid of Doctor Bills Than They Are of Being Sick

The skyrocketing cost of healthcare has become prohibitive for many Americans. More people seem to be skipping physician visits, and U.S. healthcare costs rose to $10,000 a year per person in

Your Meat Is Treated with Carbon Monoxide to Make It Look Fresh

When you are looking for a nice steak, pork chops or chicken at your grocery store one of the main things you look for is the color of the meat.

Anxiety? 10 Foods You Should Be Eating (and What To Avoid!)

Occasional anxiety is a part of life. You may feel anxious when faced with a problem at work, before making a big change, or deciding on an important decision. But anxiety disorders

5 Gig Economy Tips That Will Help You Succeed

The gig economy has been expanding at a scorching pace, with some surveys indicating that nearly one in three American workers now participate in it, whether part-time or full-time. A

7 Genius Food Tricks You Can Do at Home

Everyone likes to have fun and cook, right? There are many cool hacks and tricks out there nowadays that make kitchen time more fun. Making time in the kitchen more

3 Powerful Ways to Invest in Mexico

Mexico has a rich and deep history that can be traced back thousands of years. The country has tourism hubs in the Caribbean and the Pacific, beautiful colonial towns and

Unclaimed Money: How to Find and Recover Your Lost 401(k) Money

A crisis is looming on the horizon — and it's not the same old story about workers who haven't saved enough. This calamity is affecting would-be retirees who can’t find

7 Profound Personal Finance Practices to Follow

Nearly 57% of American adults have savings of less than $1,000, while 39% have zero savings. Following a few quintessential personal finance practices, however, can help you achieve a healthier

FIRE Your Old Financial Life and Retire Early. Here’s How…

A Chicago flight attendant has hit the news for turning her financial life around. At 39, Bianca DiValerio was nearly broke after a divorce and the sale of several failing

Interview: Rates Will Stay Low, Uber ‘to the Moon’

Don't expect the Federal Reserve to even tap on the brakes anytime soon, says Bob Iaccino, editor of the Stock Think Tank. On Thursday, Fed Chairman Jerome threw cold water