Using Options for Hedging Market Cycles and Tail Risks

There are many signs suggesting that the current economic business cycle, debt cycle and market cycle are in the mature to late stages. In traditional manner, there will eventually be a peak to trough correction that will play out no different then any other time in the past. As we approach the inevitable, the buy and hold, long-term focused money managers will lean heavily upon the countless pages of academic studies suggesting a well diversified portfolio with a long-term focus is the most practical way for an investor to ride out the cycle. Alternatively, to the other extreme, the permabears will continue to sound the alarm bells and cry for investors to move to the sidelines. Between the two polar opposite views are any countless number of variations of active management approaches, systematic strategies and market timing techniques to make any investors head spin. What is an investor to do?

Answering the question involves understanding the modern investor and the major trends that have led to how they are invested today.
So, what do almost all investors want? A low cost, low risk strategy with above average returns. (That is as realistic to get as asking for a pet unicorn for Christmas).

With the evidence in hand, the passive index investor demonstrates that by eliminating active management fees, passive investing has outperformed 85% of active managers and most hedge funds. This story has created an amazing phenomenon as mass migration of investors, both institutional and retail, move to passive methodologies.

This, in my opinion, has created many new risks that investors have not yet fully digested. What are those risks?

1. The concentration of all investors into the same investments means it is virtually impossible to outperform the market, because the investor “is” the market. In today’s zero to negative interest rate environment, the prices of almost all assets are priced at decade high multiples offering a diminishing probability of any real returns.
2. The markets are increasingly less efficient in pricing discrepancies. An example of this is observing the large weighting of energy stocks in the Canadian TSX60 indices. A flood of money from passive index buying and income fund buying systematically and indiscriminately buys the stocks based on market cap weightings, irrespective of valuations. This has the vast majority of energy companies trading at decade high multiples at a time where oil prices, revenues and earnings have not yet recovered.
3. The risk that passive investing turns to active selling in a period where losses trigger emotional risk aversion. The herding of investors could increasingly trigger a cascade of selling as many systematic tactical asset allocation models could trigger a British Pound style flash crash as liquidity, or more accurately a lack of liquidity, spurs fast drops during inevitable market declines. This could unexpectedly trigger the passive investor to be come an emotionally active seller as self preservation and risk aversion becomes overpowering.

The likely outcome of all this is that this modern investor that is seeking a “low fee, low risk, above average return” will experience the exact opposite outcome. A low fee, below average return with gut wrenching volatility.

So back to the question from the start. What is an investor to do?

Hedge the tail risk! What spurs an investor to abandon passive investing and become an active seller? The fear of catastrophic loss. It is not about a 10% correction, but rather the idea that your $1,000,000 portfolio may experience paper losses that could see the market value be worth $500,000 or lower. Sure, over the long-term history suggests it will be fine, but it does not diminish the pain and stress one endures during the period of uncertainty about issues like retirement and income.

So why not remove the risk of catastrophic loss without selling your investments?

The key to effective risk management or above average returns is to do something different then the herd. Incorporating options into your investment portfolio is one of the most accessible ways a Canadian can do that, including in registered accounts like RRSPs, RIFFs, RESPs and TFSAs.

In this example, we have an investor that controls a $1,000,000 portfolio which is diversified into several passive index ETFs. A part of that portfolio is a position in 10,000 shares of the iShares S&P/TSX60 Index ETF (TSX:XIU). Our investor recognizes that the current market cycle is relatively mature, and is looking for a way to remove the tail risk of a sharp market decline. In this case the investor creates a ratio collar using options.

• The XIU is trading at $21.94 (October 31, 2016)
• Our investor owns 10,000 shares or $219,400.00 of the XIU
• Investor is looking to remove all risk below $19.00, or all risk of loss greater than 13.40%
• The investor buys 100 contracts of the March 2017 $19.000 puts (asking $0.24) for a total cost of $2,400.00 (debit)
• The investor sells 50 contracts of the March 2017 $22.50 covered calls (biding $0.50) for a net income of $2,500.00 (credit)

What has the investor created?

An options hedge that was built at NO COST! A scenario where they are collecting the 2.77% dividend on the entire 10,000 shares owned. The investor has 100% of the upside on 5,000 shares. A potential obligation to sell the remaining 5,000 shares at $22.50 or 2.50% higher than where the stock is trading right now. With this comes a protective put hedge that removes all risk of loss below $19.00 a share creating a maximum loss of -13.40% + dividends received. An investor with this type of a hedge wrap, would easily be able to withstand the urge to panic sell during a market crash, as they have defined the maximum loss well in advance.

This is just one, of many ways an investor can use options to leverage returns, hedge risk or increase income. If this sounds appealing to you, it may be time to learn how to use options in your investment portfolio.