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.

pot stock

Pot Stock ‘Blood in the Streets’ Buy Signal Is Here

The cannabis market has been a volatile space in recent years. A wave in legalization, particularly in Canada but also through parts of the United States, led to significant growth

Use Options as Portfolio Insurance in Rocky Times

Since the beginning of September we have seen the main U.S. indices drop. There are a number of possible reasons for the decline, but more importantly I expect the increased

4 Foreign Countries Where You Can Retire On Social Security Alone

Someone once said that retirement is not the end of the road but a highway opening to a new chapter in life. Whoever said that clearly has never experienced a

We’re Beating the Index Off the March Low: Update

The Bulletproof Wealth Report model portfolio is continuing to perform well and is now up 27.4% since the inception of our monthly newsletter on April 13, 2018. Although the value

Terrible Tuesday: Fed’s Powell Says U.S. Faces Slow, Uncertain Recovery

Powell testifies before Congress today. We already know what he's going to say though, as his testimony is pre-released. Not that that will stop the market from acting shocked when

5 Best Online Banks, Highest Savings Rates for Your Buck

Finding an online bank can be difficult. Varying rates, hidden fees and simply having too many choices can cause confusion and make it hard to get started. Set aside some

Hiring a Financial Advisor: What Is a Fiduciary, and Why Should You Care?

“Fiduciary” is a funny word. You may have never heard of it until now, but you may actually have had a fiduciary in your life. More importantly, you may wish

Trading Cryptocurrency Using Limit and Stop Orders

This is the last of a five-part series to help new investors and traders start and grow a cryptocurrency account. In all five articles I’ve been using Bitcoin (BTC) in

3 Cheap ETFs Combine to Create a Powerful Value Stock Opportunity

As I steadily increase my overall equity exposure to a measurable value bias, I do so using just three passive ETFs that are consistently near the top of their respective

Options: This ETF Could Bring a Triple-Digit Gain as the Economy Gains Steam

If we go back to February 19, when the S&P 500 peaked at what was an all-time high at the time, the market has gone through five phases since then.

dividend stock investing

Make Money While You Sleep with Dividend Stock Investing

Famed investor Warren Buffett once said, "If you don't find a way to make money while you sleep, you will work until you die." Dividend stock investing is a exactly

5 Ways to Slash Your Food Spending and Save Money

The average American spends up to 10 percent of their disposable income on food, according to the USDA. Things are likely different due to the coronavirus, but the typical divide