When market headlines are continuously showing new all-time highs, many people start to think about possible exhaustion in the market and, therefore, a potential coming market correction. That is why you should have these strategies within the arsenal that allow you to have proper risk management of the portfolio. Generally speaking, these strategies about hedging should not be used very often because they are expensive in most cases.
In the following sections, you will find a general overview of portfolio strategies in recessions, why using options is a good way to go, the market correction stages, what you need to deploy these strategies, and finally, a few tips and best practices.
Portfolio Strategies in recession
The perfect hedge would be moving to cash. Once the correction is over, reinvest. That sounds simple, but it is the best way to handle this sort of situation. However, for many conditions, going to cash is not the obvious path. In these cases, reallocating part of your money into defensive assets is plausible too:
- Fixed Income (Treasuries and Investment Grade)
- Defensive sectors & stable dividends
Ultimately, you could opt for a Portfolio Hedge strategy. In this case, you could buy put options to protect your portfolio:
- It is handy when you expect corrections more significant than 5%.
- Own stocks/ETF, do not wish to sell any holdings.
Portfolio Hedge Strategy
It is a kind of insurance policy for your portfolio during a correction. It involves purchasing a put option on the broad-based index (ETF or Index). The profit from puts offset portfolio losses. However, you should be aware that it creates an imperfect partial hedge. Moreover, it is expensive because of its recurring cost from constant hedging, and it requires active management and timing.
Before dive deeper into how to set up this strategy efficiently, let’s take a look at the states of a market correction.
Stages of a Market Correction
Stage 1 – Market Top: Markets stalls, signs of exhaustion, overbought. The market-topping phase can last for weeks or months. Here, you could sell either covered calls or call credit spreads to collect the premium.
Stage 2 – Correction Starts: Since volatility metrics are some of the best metrics to gauge whether the market is entering a more corrective phase, there are quick checks to look at for giving an idea of what is happening. Enter hedge during a correction, bear market when:
- VIX 3-Month VIX/VIX Ration Falls below 1
- VIX > 3-Month VIX
If you see this type of fear from the VIX, that usually means that we are entering a major bear market correction instead of a short-term pull-back (3%-5%). These short-term pull-backs usually happen when you do not see the VIX inverting in terms of contango, but when you start to see a big structural sell-off of 15%-30%.
Stage 3 – Capitulation, Market Bottom: The question here is, how do you know when you want to take off the hedge. The volatility provides some insights.
The volatility peaks a few days before market bottoms. Usually, the market continues to move lower after VIX peaks.
When you see at the very bottom, all the last sellers are done selling. When you tend to see the markets continue to fall with volatility falling at the same time, that’s usually a good indication that, at least temporarily, the sell-off is easing off.
Optimal Portfolio Hedges
How can you actually hedge your portfolio? Well, there are three key elements you should consider for hedging with options: Index selection, expiration dates, and strike price for puts.
First and foremost, you should pick an index correlated to your portfolio. In other words, it should mimic in some way your allocations—for instance, Well Diversified portfolio -> SP&500 Index.
Now, you should look at put option expiration dates according to how big you are expecting the correction to be:
- Hedging smaller pullbacks (3%-5%): Short-dated options (1-2 weeks) to maximize Gamma. In this scenario, ATM or slightly ITM options make sense provides you high gamma exposure. It also translates to delta protection very quickly if you get that acceleration to the downside.
- Hedging smaller pullbacks (>5%-10%): Longer-dated options (>2 months) to minimize time decay.
Finally, when selecting strike prices, you should look at the same principle for an insurance policy. The cheaper your insurance is, the more catastrophic insurance you get:
- Catastrophic – Major downside correction: Buy OTM puts with 30-40 Delta. It should cost 1%-3% of portfolio value. It will only protect if there is a major market correction. In all other scenarios, you give up the premium you paid.
- Comprehensive – Any downside correction: Buy ITM puts with 50-60 Delta. It should cost you 3%-5% of portfolio value, but it will provide any protection for any downside movement.
Hedging Tips and Best Practices
If you are thinking: well, I would activate my hedging strategy all the time, you should know that constant hedging is not cost-efficient. That is why it is recommended to be better late than early -only hedge when you are bearish-.
To be tactical, you could sell covered calls and credit spreads to offset hedging costs of buying puts and start collecting those premiums. That is because when a downside acceleration happens, puts are going to be expensive.
As a final remark, you could also use debit spreads instead of put options to express your expectations on a possible market correction. It is an even worse hedge for your portfolio (it limits your protection level); however, it is less expensive and better for small accounts. Nevertheless, you may be underperforming after a while because the short leg starts to offset the long leg’s gains. It is useful if you have a defined view.
Disclaimer: Types of securities, forms, and research tools used in this post are for demonstration purposes only and should not be considered a recommendation by Trading Enigma or a solicitation or an offer to buy or sell any security. This post is not intended to be used for individual tax, legal, or investment planning advice.